Unstoppable: Why this crisis will keep unfolding

Balls of euro banknotes

Image by Salvatore Vuono

When the tectonic plates underneath society shift, confusion reigns, together with wishful thinking.

It appears that financial markets have again managed to get themselves into a state of unrealistic expectation. The European summit this coming Sunday (or the follow-up summit on Wednesday) is now supposed to bring a “comprehensive plan” to solve the European debt crisis. Of course, nothing of the sort will happen, and for a simple reason: it is impossible. Those who cherish such fanciful hopes are naïve and will be disappointed.

Let’s step back and look at the problem, which in a nutshell is this: The dominant societal model of the second half of the twentieth century – the social democratic nation state with its high levels of taxation, regulation and stifling market intervention, and thus increasingly dependent on a constantly expanding fiat money supply and artificially cheap credit -is rapidly approaching its logical endpoint everywhere, not just in Europe: excessive and unmanageable piles of debt, systemic financial fragility and weak growth.

For many, including quite a few of those demonstrating under the ‘Occupy Wall Street’ banner, this whole mess deserves the label “crisis of capitalism”.  That this is nonsense I explained here. What we are witnessing is not the crisis of capitalism but the failure of statism. The present system, certainly the financial system, has very little to do with true capitalism, and if financial markets are now being demonized for their failure to go on funding political Ponzi-Schemes, than this means shooting the messenger rather than addressing, or even understanding, the root causes of the malaise. As I said, this is also a time of great confusion.

Failure of statism

The monetary madness of recent decades was only made possible by the transition from apolitical and inflexible commodity money (free-market money) towards limitless, entirely discretionary fiat money (state money). This shift was completed on August 15, 1971, when this system was also made global. What does such a monetary system logically entail?

In a complete paper money system, banks cannot be private capitalist enterprises but must be extensions of the state because the state holds the monopoly of unrestricted money creation. The banking sector is cartelized under the state central bank. To operate a bank, you need a state license that requires that you open an account with the central bank.

Image of euro banknotes and coins

Photograph by M. Bartosch

In such a system, the central bank can create bank reserves out of thin air and without limit, and has thus full control over the level and the cost of such reserves. The central bank has therefore ultimate control over the funding of the banks and the availability of credit in the economy – which is now supposed to be magically freed from its natural constraint under capitalism: voluntary savings.

In such a system, it is generally assumed that the state cannot go bankrupt as it can always print more money to fund itself. It is equally assumed that the banks cannot fail and do not ever have to shrink, at least collectively, as ever more bank reserves can be made available to them – if need be at no cost, as has become – now that the system arrived at the point of ultimate excess – the global norm.

It can hardly be surprising that those who are in charge of the banks and those who are in charge of state finances have behaved for decades as if the Great Regulator of economic life, the threat of bankruptcy, was of no concern to them. Now that the system has finally overdosed on cheap credit and that the forty-year fiat-money-fed boom is over, reality is sinking in. And it comes as a shock.

There is a lot of talk of return to normality. The market has, of course, a way of returning to normality, which involves liquidating the excesses, clearing out the dislocations, defaulting what will not be repaid, and deflating prices that do not reflect real demand. Liquidation, default and deflation, however, are politically unacceptable, as they cut right to the core of our system of state-managed ‘capitalism’: the notion that the state is above the laws of economics and that it can bestow a similar immunity on its protectorates, most importantly the banks.

What’s EUR2 trillion among friends?

Back to the alternate reality of the policy debate in Europe. The hope of many financial market participants seems to be that the summit will reveal measures by Germany and France to erect a firewall around Greece in case it will default, that the banks will get ‘recapitalized’, and that steps will be taken toward further ‘fiscal integration’. The wish here is evidently that Big Daddy will finally step forward, that he draws a line in the sand, and says, hey, this stops here. Time out on the crisis.

There is only one problem: Nobody has the money to do it.

Two days ago the British newspaper The Guardian broke the story, unconfirmed so far, that Germany and France had agreed to a EUR2 trillion bailout fund. In response, equity markets around the world enjoyed a brief rally. Finally, the big bazooka had arrived.

Really? I was wondering if nobody ever heard of Brian Cowen.

He was the hapless Irish chap who in 2008 played Big Daddy himself and implemented an official government back-stop for the Irish banks. And duly bankrupted his country.

Brian Cowen

Life of Brian (Image by Maxime Bernier)

If Merkel and Sarkozy were really stupid enough to launch a EUR2 trillion bailout fund, it would certainly pay to go short French BTANs and German Bunds right away. Germany and France have no money to bailout anyone. All they could do is pile on more debt on the already large and ever-growing debt pile of their own. It would not take the market as long as it did in 2008, in the case of Ireland, to figure out what the endgame must look like.

But surely, everyone involved must realize that the little boy in the crowd has already pointed out that Emperor Sarkozy and Empress Merkel have no clothes. Interest spreads on French bonds have already blown out, and Moody’s has warned that France’s AAA-rating (what? Triple-A?) might come under review. Credit-default spreads on German bunds have widened of late, and the cost of insuring against the bankruptcy of the Bundesrepublik Deutschland will most certainly only go one way: up. Have I mentioned that Bunds are the short of the century, and U.S. Treasuries, too?

The whole notion of ‘ring-fencing’ Greece is, of course, absurd, as if Greece had contracted some rare contagious disease from which healthier nations, such as Italy or Spain, had to be isolated. Ongoing, endless fiscal deterioration is, however, not a virus but a self-inflicted and ultimately fatal wound that all European states, and in fact, almost all modern social democratic states are already suffering from. The difference between Greece and Germany is one of degree, not principle.

For these reasons, the idea that some form of ‘fiscal integration’ could be the solution, is equally absurd, as if pooling the finances of the already-bankrupt and the almost-bankrupt will somehow give you a community of the fiscally strong, as if you could improve the financial standing of a trailer park community, in which some inhabitants are maxed out on their credit cards while others still have some borrowing capacity left, by giving all of them a joined bank account.

So does this mean that all political options are exhausted, that default, liquidation, and deflation are now unavoidable?

It will get worse

Not so fast. There are still some options left to governments. None of them will solve the problem, all of them will make the crisis worse. All of them are scarily ugly and destructive. Of course, I expect that all will be adopted by governments soon.

Eurotower in Frankfurt

Unlimited Euros!, photo by Florian K.

There is, of course, always the prospect of growing regulation and market intervention, of capital controls and the banning of short selling of government debt. I expect all of this to be enacted at some point in the not-too-distant future. Like all government intervention, it will make things worse and accelerate the demise of the system.

But the biggest of all policy mistakes is already being made, and we will get more of it, much more of it: printing ever more money ever faster.

The ECB will be forced/asked/convinced to support the market for government debt of ever more European states to an ever larger degree. Central banks and fiat money are not creations of the free market but of politics. Their role has always been to fund the state. We have already reached the point at which all major central banks are dominant buyers, frequently the largest marginal buyers, of their governments’ debt. The U.S. Fed is already the single largest holder of U.S. Treasuries, and when the just-announced second round of ‘quantitative easing’ in Britain will have been completed, the Bank of England will own almost a quarter of all outstanding Gilts. Funding the state directly with the printing press is the logical penultimate stage of the demise of the present global fiat money system, and all major economies are approaching it fast. The eurozone will be no exception. The ultimate step is loss of confidence in paper money and inflationary meltdown.

If there is one outcome from the European debt summit that I am most convinced about it is that another crucial step will be taken to accelerate the ongoing debasement of fiat money.

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Europe's future is coming into focus: hyperinflation
The second crisis of socialism


  1. wesley mouch says

    Is there a way for the individual to protect himself other than holding physical gold? Shorting bonds is probably over the head of the average investor. What are your thoughts on silver? It has served as money as long as and in more situations than gold and is less likely to be confiscated? Thanks again.

    • says

      Wesley, shorting bonds is maybe a bit complex for many. And I am not sure for how long the state will allow anyone to short government bonds. It may soon be declared anti-social behavior, an unmistakable display of lack of solidarity. But I would certainly not own these bonds. (Disclaimer here: this is my personal view and for information purposes only. I am not giving investment advice but expressing personal opinions.) In all fiat money crises, the people who get hurt most are those who save, which in most societies are the middle class. These people not only save (which makes them the pillars of the capitalist system) they also save mainly in the form of bank deposits and fixed income securities. These assets get wiped out in a hyperinflation – and so does the middle class. So my recommendation is to minimize exposure to the banks and the state, not to hold government bonds (or any bonds for that matter) and try not to depend on government transfers for your income. These transfers will not be inflation-adjusted, if they get paid at all. If you don’t hold bonds yourself, chances are your pension fund does. In this environment, real assets beat paper assets. Gold is, I believe, the number one self-defense asset. Silver is OK. I have nothing against silver. Personally, I prefer gold. Gold is a monetary asset and an industrial commodity. I am interested in it as a monetary asset. Silver is less of a monetary asset and more of an industrial commodity when compared to gold. Also, gold is more expensive which means you need less gold to store a given amount of present “paper” wealth. Gold, for me at least, is number one. Other real assets of interest could be land (arable land and forestry), real estate (not of the highly leveraged nature) and even certain equities, companies with good solid products, strong market positions in a specific niche, strong cash flow. I am not an expert on equities at all but I believe that good, solid productive capital is always needed in society. You just need to find companies that make it through the valley of tears and are still standing when we arrive on the other side.

    • says

      Sorry Ron, I don’t quite understand the question. In my view, a monetary theory is either correct, in which case in applies to every country, or it is wrong, in which case it applies to nowhere and should be discarded. MMT seems to belong to the latter category.

  2. John Campbell says

    Thank you so much for your book and your further writing here. I am sorry that I only just came to the realization that we are nearing the revolution you describe, to destroy the status quo. A few fitful nights reading your book convinced me of your analysis – not if, but when will the end come.

    In an interview you recently gave, you estimated that the hyper-inflation endgame would happen in two to five years. I know that this is somewhere between prophesy and prediction, but the time line seems reasonable to me.

    Now I would ask if you could climb farther out on that limb. Can you give us a sense of how long it may take to right the world’s or a country’s fiscal order with a non-commodity money system? I realize that the reality will depend upon too many factors to make anything more than educated guess. But how long can we expect the enormous disruption to last before the economy begins to recover and grow again? I am looking for some sense of the order of magnitude for the time line – two years? A decade? Longer?

    It would be interesting if you could speculate how the crisis and recovery might play out.

    I would also be interested to know what would happen if a single country – say Canada he suggests hopefully – made a determined effort on its own to establish a commodity based money system ahead of a global crisis. How could that play out? Could success there encourage more countries to follow suit? Would that speed the recovery?

    Thank you for this introduction to rational economics. I was aware of von Mises and Rothbard from reading Ayn Rand and was convinced of their premises before this, but it took your book to make it clear to me how important these ideas are. One cannot evade them. I will give your book to my two children as their introduction to rational economics. And I am loading up my Kindle with more rational economics. Your book was a pleasure to read, after one gets past the sobering message for the near future. I look forward to more books from you.

    • says

      Hi John, thank you very much for your kind message. As I am sure you gathered from my interview, I am always a bit hesitant to give a specific time frame or to try and predict exactly how things will unravel. In fact, there is no time frame given in my book. The reason for the “2-5 years” in my interview is simply that I wanted to get across the idea that this could happen soon (it may happen next week for all we know) but also drag out a bit longer, but that I do not believe it is something for us to worry about only in ten or twenty years from now. A friend of mine once said, Detlev, your analysis is correct but this could take another 20 years. Well, maybe. But I sure don’t think so. The next 5 years are going to bring a massive crisis and some substantial change.
      Doug Casey was asked what he thought the U.S. government should do. His answer, if I remember correctly, was something like this: default on the debt, stop the wars, cut 95% of government spending, abolish the Fed and return to free market money, i.e. a true gold standard. I agree with him 100% but I think we all agree (including Doug) that this will not happen anytime soon. But here is my point: If this were to be done next week, we would face a deflationary correction, a recession. Statistical measures of growth (which include government spending and government waste) would drop, many banks would fail, many prices would fall. The market would finally be allowed to cleanse the system of a lot of the unproductive or marginally productive nonsense that is presently masquerading as sustainable economic activity. There would be a crisis by any accepted measure of economic activity. But it wouldn’t last long. Not even two years, I am sure. In a free market, based on hard money, economic activity would quickly get redirected. Soon, the economy would grow again, and grow and continue to grow at a sustainable rate, generating real wealth and prosperity, not pseudo-wealth based on constant inflation and monetary debasement.
      Reality is not optional. What is unsustainable will ultimately get washed away. But given that no politician is going to enact Doug’s plan voluntarily, the complete breakdown will now come later (probably but could be fairly soon) in the form of a hyperinflationary meltdown – which is going to be much worse than Doug’s crisis. So all that policy can and will do is this: drag this out and make the endgame worse. But once collapse occurs, the recovery afterwards could be fairly swift. In that I am an optimist. It requires, however, that after the crisis we do get hard money and less government, and not some fascist super state with a new global fiat currency. For various reasons, I think that the latter is unlikely but now we are really in the realm of speculation.
      If I may, I will keep my answers to the questions about single countries returning to a gold standard for a blog I intend to do soon that will address “frequently asked questions” – many on the topic of ways to return to gold money. Just this much here: Yes, I do think single countries could return to hard money. Politically, they need to accept that no interest group would then be able to influence interest rates or exchange rates. This might not be easy considering recent political practice (a good illustration of this problem is Switzerland where a commitment to debase the local paper money at a slower pace than major neighbors was weakened out of misplaced concern for the export industry and the banks) but it would be well worth it. But it is easier if more countries make the transition at the same time. I agree with you that the quicker the transition is being made the quicker dislocations will be unwound and growth will resume. Other countries would then follow.

      • John Campbell says

        Thanks Detlev for your reply. Your clear thinking and writing is a treat. Following that I have to ask if you are familiar with David Deutsch? He is a physicist and philosopher who recently wrote the wonderful book, The Beginning of Infinity. He and you have reignited my intellectual curiosity profoundly, after a protracted period of just working. Deutsch comes across very much as sympathetic to Libertarian ideas and I suspect he would lean to the Austrian School in economics as well. He is a very deep and inspiring thinker.

        Thank you again for your inspiration and your powers of explanation.

  3. Ross Smith says

    Continuously amazed at your ability to condense complex issues into their essential components and reveal the underlying prime drivers.
    An appreciative reader.

    • Stephan F. says

      Mr. Smith:

      I couldn’t agree more. Detlev’s clear & rational thinking and no-nonsense writing style is most impressive. I must admit he is one of the few writers I’ve come across in my lifetime that, pound for pound, gets more mileage out of a line of print than anyone I can think of. Let’s take up a collection and clone this guy. And if he ever decides to sell stock in himself, I’m buying.

  4. Craig says

    I just followed a link here from GoldMoney.com’s Facebook feed. I first started following the details of the whole fiat currency debacle as little as 12 months ago. Since that time I’ve thrown myself wholeheartedly into understanding the global fiat system and surrounding issues. And I must say this is a great article and best summing up in a short piece that I’ve seen so far. Great stuff Detlev, I’ll most certainly be following your commentary from now on.

  5. says

    Whilst I will agree with this analysis of cheatable fiat currency, and I am more than happy to look to gold as a cure to artificial creation of intrinsic wealth, I think one crucial thing is overlooked.

    There is only one currency in this world and that is energy both it’s visible and hidden costs. Please read my article “Economic Collapse ignorance is Bliss” At http://outsider.me.uk for my proposed Laws of Energy Economics, I hope to get us all thinking about energy in a new way.

  6. Jim Richards says

    Overlords = Statists, Monetarists, and Central Planners.

    Personally, just speaking for myself, I would not short U.S. Treasuries. You’re talking about trying to take advantage of the Overlords. Same thing with the currency markets. I wouldn’t play with it due to the control the Overlords have of them. Swiss Franc anyone? You really think that the Overlords are going to let you in on the joke they’re playing on us with their own financial instruments of destruction that they created and have control of?

    If you really want to beat The Powers That Be, the Overlords, at their game… there’s a choice that I believe that has no counter-party risk, cannot be debased and debauched, and they cannot monetize it’s debt because it does not represent debt. That is sound honest solid hard money… Gold and Silver.

    The Statists, Monetarists, Central Planners, and Financial Engineers do not create Gold and Silver, and do not control physically possessed precious metals. Although I bet they wish they could, because they seem to want to control… everything. Perhaps they are a victim of the dictator fallacy. Or perhaps they are out and out proponents of dictatorships and wish they could be a dictator. You have to actually work to get Gold and Silver. Real actual work, producing something people actually want, something besides the creation of debt. That’s something those guys do not seem to understand.

    Paper, backed by nothing fiat currencies, are a joke. But guess what. If you own Gold and Silver, you’re in on the joke!

    • Manfred says

      So one trades Bund and/or Treasury Futures on a daily basis, i.e. sleeps naked,
      and buys gold and silver from the proceeds.

  7. says

    It seems that QE3 is coming very soon since the FED is the central bank to the world and the world is deflating again so they need to create credits. They do not want a repeat of the 1930s or 2008 but a repeat of the 1970s so inflation will burn up debt

  8. Laird says

    Detlev, I understand the point of avoiding government (or any) bonds and acquiring real assets. But if the coming monetary collapse is going to wipe out savings, would it not make sense to buy physical assets (gold, arable land, whatever) using as much leverage (borrowed funds) as possible? That way you control more real assets and if we do suffer from hyperinflation you’d pay back the loan with devalued currency.

    • says

      The short answer is, yes, it does make sense. But I would still be careful with this strategy. The timing of it and also your personal risk-tolerance are very important here. Before I explain this in more detail, let me repeat my usual disclaimer: This is for information purposes only. I am not giving anybody investment advice. I am expressing personal opinions.
      I think it is very likely that monetary authorities around the world will continue to produce ever more currency units. Why? Because the imbalances that 40 years of ceaseless fiat money expansion have created globally are now so gargantuan that their liquidation through market forces will be deemed politically unacceptable. So, on trend, ever more money is being printed ever faster. If you share this outlook it would make sense to invest fully in real assets and to then to extend your personal balance sheet by borrowing funds and buying more real assets. But investing is not just about being right but also about being able to sleep at night. Even if this strategy is ultimately the right one, you also have to survive the path of this strategy through time, that is, the mark-to-market swings that might occur, and maybe here the challenge will be more psychological than monetary but it still matters. Let’s take an example: I have a big position in gold but when the gold price drops, as it did recently, I can add to my position because I have some firepower left. Now let’s assume someone who is long gold 120%. All of his wealth is in gold and he has a 20% levered position in gold on top of his unleveraged holdings. Whenever gold goes down, he will not sleep well at night. In fact, he might be facing margin calls on his borrowed gold. This would be similar if he had levered positions in real estate.
      That is what I meant by personal risk tolerance. I, personally, want to sleep well at night and not be held hostage to market volatility. That is where timing comes in as well. If you can be sure that the big inflation will come next week (as it very well might) you can go max long on your real asset strategy. But what if it takes another year?
      Let’s not forget that in the current environment an epic battle is going on between deflationary forces and inflationary forces. If the market were free to liquidate misallocations of capital, we would face a deflationary correction. Many prices would drop, including those of many real assets. But the market is not free, and policy is introducing inflationary counterforces. But what if we went through a six month period of dominance of deflation – lower equity prices, lower real estate prices, a lower gold price – as central bankers are nervous and a bit reluctant to inject money too aggressively. Let me be very clear here: This is not my outlook at all. But it is feasible. Were this to happen, I could still sit back, be relaxed and wait for the next inflationary policy push to come. A period of less aggressive monetary policy (again, NOT my expectation) would not invalidate my thesis at all, and not even my overall market outlook. My friend, however, the one who is 120% long real assets, would have a horrid time.
      So, intellectually the strategy is absolutely correct. It is all in the implementation. In every crisis, there are winners. Those who get their timing right and who have tremendous guts. Maybe that is not my forte. I am content with understanding what goes on better than many others — and survive!

      • Tom says

        This is a very good point, Detlev! Timing correctly is extremely difficult. Maximizing profit can only come as a function of managing risk extremely well. Speaking of which, I can only hope that Ron Paul gets the Republican nomination, US presidency, and media attention that he deserves. He is the only one that can represent us, through his policy of anarcho-capitalism and non-intervention. Otherwise, we are all pretty much doomed.

  9. Ahmed says

    Detlev, thanks for your courageous and insightful stance. I am looking forward for the delivery of your book which I imagine will be as structured and rigorous as your blog.The demise of fiat currencies will obviously have a highly disruptive effect on capital markets though as you suggested previously may still be supportive for certain stock market sectors. What do you think will be the structural impact on financial services ? Specifically, can hedge funds and asset managers survive post paper-money collapse given that a large part of their AUM growth (through 401ks and pension funds) was driven by the debt bubble ? The reason I ask this is that as much as the IB model may disappear, there will be always a need for managing money (pensions, savings) even in a highly inflationary environment or in a gold-based standard. But how could the industry adapt to this 100 standard deviation event ?

    • says

      Ahmed, you are right: There will always be demand for good investment management services. The backbone of the free market system is savings, and as long as people save they will have demand for professional services that help them keep these savings and generate a good return on them. I even think that, had we stuck to the free market and kept hard commodity money instead of implementing an inflationary fiat money system, the financial industry would still have grown, in particular asset management. In a stable monetary environment people have an incentive to accumulate savings. As savings grow, so does the demand for savings-related financial services. However, on the basis of our inflationary fiat money system, the entire financial industry has practically exploded in size. It is now of a magnitude that is simply disproportionate and completely unsustainable, in particular as a consequence of what happened over the past 30 years or so, when new money was channeled mainly into financial assets and real estate where the inflationary impact was staggering. So the first thing that will come out of the inevitable fiat money demise will be a drastic and painful shrinking of the financial industry, all of it, including asset management. Finance in the next decade is what the coal industry was in the 80s. This is going to hurt.
      I think this will be extremely painful in fixed income. Look at the investment grade bond universe today. I bet that 90 percent of it, or there about, is government bonds, bank bonds and mortgage-backed securities. All these sectors have now officially, clinically overdosed on cheap credit. They are all bust now. As an investor you face a dreadful choice: either many of these bonds will default (as they should), or that is deemed politically unacceptable, so you will get massive inflation, at the end of which the bonds will still default (as I explained many times, the debt pile is now way too big for some elegant “inflating away” of the debt. That didn’t work in Weimar Germany and it won’t work this time around.) So it’s either default now or default later, and in the case of “default later” you get hyperinflation and all your other bonds in your portfolio become worthless, too. Fixed income is a lose-lose for the investor. In fact, these assets should not be called assets, they are liabilities, even for the investor. I hate to say this because I worked for 19 years in fixed income and most of these years in bond portfolio management, and I still have many friends in that industry, but from where I am sitting bond management is the death trap of financial services.
      As the entire sector will shrink, so will hedge funds. In fact, I think they will shrink more. If we look at what’s been happening as one gigantic credit cycle that has now turned from boom to bust, it is clear that hedge funds were a late-cycle phenomenon, the white foam at the cusp of the wave just before it collapsed. Between 1997 and 2007, the last decade of the credit boom, central banks were still succeeding in papering over (no pun intended) most glitches in the already overstretched global credit edifice by throwing ever larger amounts of money at it and judiciously cutting rates whenever problems surfaced. This was the time of the Greenspan put, of overabundant market liquidity. The raison d’etre of the hedge fund industry is cheap funding, ample credit lines and massive market liquidity that allows their managers to take the average trade and – via leverage – generate outsized returns with it. Those days are over. And they are over for good.
      Talented traders are far and few between. The hedge fund industry has attracted some of the talented few, of course. Those folks may still do well and their services in demand – but the business model of the industry does not look good to me for the environment we will be in for the foreseeable future.

  10. TK says

    Congratulations on your blog. Very informative and interesting.

    I have a question regarding fractional-reserve banking. I wonder whether a similar process can’t happen in a free-market. Imagine we have anarcho-capitalism and people use gold as their currency. Now:

    Person A produces stuff and sells it for 10 oz of gold
    Person A lends 10 oz of gold to Person B at 5% interest
    Person B buys stuff or services from Person C for a total of 10 oz of gold
    Person C lends 10 oz of gold to Person D at 5% interest
    Person D buys stuff or services from Person E for a total of 10 oz of gold
    Person E lends 10 oz of gold to Person F at 5% interest
    Person F buys stuff or services from Person G for a total of 10 oz of gold
    Person G lends 10 oz of gold to Person H at 5% interest

    And all this happens on the same day. Now, the result is that multiple loans and commercial transactions using the same 10 oz of gold have created 42 oz of gold worth of loans. Please note that no bank was involved, all transactions were voluntary and there is no paper currency. So how is it different from what commercial banks do today with deposits and loans? On surface, it seems the same happens and banks act only as an intermediary between lenders and borrowers.

    I would appreciate your take on this.

    • says

      TK, what you are describing has nothing to do with fractional-reserve banking. The 10oz of gold pass through your model economy and facilitate various transactions, including loan transactions. That’s what money is there for. Your example only illustrates – to a degree- that any given amount of gold can facilitate any number of transactions, and that it is therefore unnecessary for a money producer to constantly inject more money – ounces of gold or paper – into the economy as the number of transactions grows. That is also a point I make in my book: Contrary to erroneous common wisdom, a growing economy does not need a growing supply of the monetary asset. But back to fractional-reserve banking. The important point is this: At each moment in time it is perfectly clear in your model who owns the money, i.e. the 10oz of gold. When A lends the 10oz of gold to B, A ceases to be the owner of gold. B is now the owner. A has exchanged ownership of money (i.e. gold) for ownership of a debt claim. When B buys stuff from C, ownership of the 10oz is transferred to C, and when C lends the gold to D, it moves on to D. At the end of the day, only one person can claim ownership of the money: H who just borrowed the 10oz from G. The money supply in your model economy was 10oz at the beginning of the day, and it is 10oz at the end of the day. The money supply has not expanded. The loan volume in the economy, expressed in ounces of gold, is 40 oz (not 42!) but this credit volume is backed by true savings. The lenders in your economy, A, C, E and G, have all obtained temporary ownership of money by producing stuff but then have not used their income to spend it but to save it and to invest it in loans to B, D, F and H, respectively. What you are describing is a very simple model of an economy based on inelastic commodity money: the money supply is fixed (10oz), all credit is backed by savings. But none of this has anything to do with fractional-reserve banking (FRB).
      If you wanted to introduce FRB, you would have to make B a banker. B would not take a loan from A but he would propose to A that A deposits some of his money, say 2oz of gold, with B. A would retain ownership of this money and had the right to demand instant delivery of the 2oz at any moment. Why would A do this and not just hang on to his cash? Because B pays him 1% p.a. on his deposit balance with B. A can now keep ownership of his 2oz of cash, retain all the flexibility of money ownership but get a bit of interest at the same time. B offers the same deal to C, E and G. As proof of their ownership of gold, A, C, E and G receive paper tickets from B that he promises to redeem for physical gold whenever presented to him. These paper tickets now circulate in the economy and are being used as media of exchange, just like physical gold. As long as B does not issue more paper tickets than he has gold in his vault the economy has not changed from your model. A, C, E and G may use the paper tickets just as they used physical gold. They may spend them or lend them to others against interest. But B has to earn the interest to pay his depositors, so he will print an additional 5oz worth of paper tickets and lend them to his loan clients, assuming that A, C, E and G will not demand repayment of their gold at the same time and thus considering it save to hold less than a 100 percent reserve. Now the circulating money supply has grown by 5oz and the volume of credit is larger than true savings. And if the paper tickets constitute a claim to gold, there are now more claims on gold circulating in the economy than there is physical gold available. For why this must lead to economic instability, please read the book.

      • TK says


        Thanks for your reply. But the example you have provided where B issues extra 5oz worth of paper tickets in excess of the 10oz deposit seems to be a fraud even under the current FRB system. As I understand the FRB, if 10oz of gold is deposited at a bank, the bank can lend out most of it, say 9oz, keeping a reserve of 1oz . It can’t lend 10oz or more than 10 oz. Unless some of the gold that has been lent returns to a bank and is deposited again by someone else. For the sake of simplicity, let’s assume that a bank can’t issue any paper tickets and the reserve ratio is 10%. Deposits and loans are made in physical gold. The bank gets a 10oz deposit and lends 9oz. After a while, this 9oz returns and is deposited at the bank. The bank lends 8.1oz, and so on… Is it not a fractional-reserve system? I thought that the real flaw of the FRB system is that it makes it possible to make long-term loans against on-demand deposits, so the real problem is not the “reserve” part but the incompatibility of the timeframes of deposits and loans.

        • says

          TK, sorry but you misunderstood my example. B creates 5oz of paper tickets and lends them, he keeps the entire 8oz of deposited gold in his vault. On 8oz of gold he thus creates 5 oz of credit. There are now paper tickets circulating in the economy – and functioning as money – with a nominal gold value of 13oz: 8 came into existence as a result of the original deposit banking, another 5 were created by the banker. The money supply has expanded. I think this example is closer to how the system works today. When central banks expand bank reserves they expect – in normal times – the banking system to use this additional reserve to create additional deposit money in excess of the reserve: the famous money multiplier.
          FRB has two problems: If it is just a chain of money-lending operations it has the timeframe problem that you mentioned. This creates the risk of bank runs and panics. To the extent that it allows a mismatch between saving and credit – as I described it and as the system works today – it also causes business cycles.
          But let me be clear that, contrary to many other Austrians, I do believe that in a free market based on commodity money there would be fractional-reserve banking, and also I do not think that FRB should be banned. FRB has destabilizing properties but in a free society it should be allowed to be practiced. In an anarcho-capitalist economy it would exist, in my view. The problem with a paper money systems and with our present system in particular is not the existence of FRB but the fact that it is state-subsidized on a massive scale: unlimited bank reserves, lender-of-last resort central banks, deposit insurance, etc. My book does not argue against the evils of FRB but the evils of fully elastic state paper money.

          • says

            I don’t think I have answered your question fully. In particular, your point about no paper tickets. If I may, I will respond later today or tomorrow as I think this is an interesting point.

        • says

          This is becoming a rather lengthy discussion of FRB but I felt that I still had not responded to your suggestion to exclude – for argument’s sake – the issuance of paper tickets (fiduciary media) and simply assume all lending occurs in physical gold. Interesting idea. Let me say this: you have now almost created a model of “immaculate fractional-reserve banking”. The way you set it up FRB would have the least disruptive impact. Let me explain: We all agree that your initial model is not really FRB but simply a model of money circulating through the economy. The supply of money is not expanded and all loans are based on voluntary savings, i.e. whoever is lending is doing so with resources he has obtained previously through acts of production, has saved and has now invested/loaned. This system is not problematic in the slightest.
          Now you change this model in the following way: A no longer lends directly to B but “deposits” his savings with the bank, let’s say M, to not get confused with B from the previous model. M now lends 90% of the deposited gold to B. Nothing fundamental has changed. M is simply a middle man. If we assume further that B spends the money (as you do in your original example and is indeed likely as few people will borrow money to deposit it again with a bank) and that C obtains control of the money again through a process of production and market income generation, then, again, nothing is different from your original model. C is now not going to lend the money directly to D, but again via the middle man, banker M. This way you have introduced FRB but stuck as close to the original, stable system. Overall loan volumes will be slightly lower in this case as M must retain a “reserve” that is not required in the original model.
          Does this model have instabilities? Of course. The difference to the original model is (as Ajax pointed out as well) that A, C, E and G think they own money that they can always pull out of the bank in physical form (gold) when in fact they have somehow “entered” long term loan agreements and M would indeed be unable to honor the claims to redeemed in instant gold. In the original model such an obfuscation does not take place. So if M gets his reserve strategy wrong, and A, C, E and G want to pull out “their” gold at the same time, the system collapses. Thus, you have created a “funny” model of FRB: the loan volume is lower and the system is less stable. Its Achilles heel is the instant redeemability, which, of course, cannot be guaranteed.
          However, you have managed to maintain an important element of your original model: new deposits only come into existence after acts of production when the producer (A,C,E and G) does not spend his income but saves it and puts it on deposit. A, C, E and G have all produced but not consumed. They have saved their entire income and that has been the basis of the loan volume in the model economy. This was the case in your original model, and it is the case in this model of “immaculate FRB”. The mismatch between saving and investment that characterizes the Austrian Business Cycle and that is associated with FRB has been avoided. It is still unstable because of the unrealistic redeemability promise but it doesn’t create a business cycle.
          However, in this model, I would argue that M does not really represent the FRB-industry but more a money manager. A, C, E and G simply use M to channel their savings to the borrowers B, D, F and H. In any case, it is not how our financial system operates today, nor how it has evolved historically.
          I still think a better model is one that introduces fiduciary media, instantly redeemable claims on money proper that are not backed by money proper (gold) but that circulate in the economy for a while as if they were backed by gold. Let’s assume that A, C, E and G deposit their gold with M and receive paper tickets in return, and that these paper tickets are accepted in lieu of physical gold. After a while A, C, E and G don’t want to hold these paper tickets anymore. They want to achieve a higher return on their savings. So they give a loan to B, D, F and H in form of these paper tickets. Additionally, M lends 1oz of deposited goal to H as well. A, C, E and G no longer think they own money, either in gold form or in paper tickets. They know they lent the money. B, D, F and H hold these paper tickets and believe they are backed by gold. H also holds an additional ounce of physical gold he has borrowed from M. It is clear that now more paper tickets are in circulation than gold is in M’s vault, and that more loans have been extended than voluntary saving has occurred. Now we also get the ingredients of an Austrian business cycle.
          I repeat, FRB is problematic but should not (and probably cannot) be banned. The more the system is based on an inelastic gold supply – as in your model – the less disruptive FRB is. The more it is based on fully elastic reserve money (today!), the more disruptive FRB is.

          • TK says


            Thanks for your lengthy reply and detailed analysis. Yes, the “immaculate FRB” that you have described is the model I had in mind. I thought that was the way FRB was supposed to work. If it did, i.e. if there were no mismatch between saving and investment, and if, on top of that, there were no mismatch between the timeframes of loans and deposits (i.e. no interest-bearing on-demand deposits), then FRB could be a valid model. There would still be risks, such as that of default, but there would be no money-printing fraud. Thanks, again.

    • Deft says

      Detlev / TK, sorry for jumping in as it was not addressed to me, but I’d like to offer my take to see if I understand the situation correctly and also ask a question of my own. Please correct me where wrong!

      TK, your example is just a chain of loans, there is no currency expansion at each stage of the loan, thus it isn’t fractional reserve. Persons B, D, F etc. use the goods either to a. produce more goods or b. consume said goods. In the former, they re-sell to make a profit after paying back the loan or in the latter they direct their other resources (labour, other goods etc.) elsewhere to earn enough to pay back the loan.

      My question (please excuse me if you have answered this in your book, but I am only approaching half way through it):

      With the above non-fractional lending, would it not require much higher levels of risk management, which could in itself stifle lending and thus cause slower economic growth? The reason I ask is if a borrower was to default then the lender takes a 100% hit. With fractional reserve, this default risk is taken into consideration. If 10% of created money defaults then 90% is still coming back eventually. At least this is the theory when the economy is stable. I appreciate that in times of dislocation and deflation this default rate can jump massively, as well as the run-on-bank risk etc.


      • Deft says

        Detlev, your above answers to TK make my question somewhat a moot point as you are not promoting a 100% reserve currency. In fact the more I read my question the more it looks like an unitelligle stream of early morning consciousness. No wonder we’re in the situation we’re in when asking the right questions is the hardest part!

  11. ajax says

    TK – I think what you are describing is loan banking vs deposit banking. The deposit banker receives money with a promise to pay on demand. The loan banker receives money with a promise to pay in the future with interest, thus enabling the banker to loan the deposit. Your description of the bank receiving 10oz and loaning out 9oz would legitimately fall under a loan deposit and would be inappropriate as a demand deposit.

    My understanding of FRB(and anybody please correct me if I’m wrong) is that the bank does create money out of thin air, receiving say 10oz and issuing out 15oz in gold receipts. Clearly the extra 5oz is money the bank has not received. It can get really bad with a low reserve requirement of say 10%. The bank could then receive a 10oz deposit(giving the depositor a legitimate 10oz paper receipt), use the 10oz’s to satisfy the reserve requirement, and create 90oz of additional paper receipts(not backed by anything), grossly increasing the money supply.

  12. Mr Ecks says

    It is not clear what has gone on at the Wednesday summit.No details (it seems) are to emerge until next month, which suggests it was not a success, otherwise they would be boosting about their sagacity already.

    The media are talking again of a one trillion dollar fund (halfway there?) including Chinese money. It seems unlikley that the Chinese govt would risk a huge quantity of cash on this lunacy but if they were crazy enough to put up huge sums, how do you think it would affect the situation?.

    • says

      The Chinese are sitting on close to a trillion dollars worth of Treasury bonds that will never be repaid with anything of real value. Why not diversify into some euro-bonds that will never be repaid with anything of real value either? All these bonds only have some imaginary accounting value at the moment. Think about it, the Chinese could never liquidate their Treasury holdings as that would crash the market and the financial system. But they cannot go to the US and exchange them for anything of real value either, such as land, houses, Disney World or Apple stock – US politicians wouldn’t allow it. That these bonds represent wealth is simply not true. They represent government waste. They will be defaulted on – either outright or via inflation. Why are the Chinese holding them? Because they are interested in maintaining the status quo for a bit longer. So are governments in the US and Europe. There are all scared by this unfolding chain of bank and state bankruptcies and fearful that the market’s spotlight will be on their own inflated situation soon. And that is why the Chinese government may dump a few hundred billion into the EFSF. Sustaining the mirage of sustainability is global policy objective number one.
      How would it affect the situation? Not much. It may give the ECB a bit more time before it will be “persuaded” to support the bailout fund with its ‘unlimited resources’.

  13. Ernst G. Pohlhausen says

    Detlev, are you German?
    My Question:

    “the social democratic nation state with its high levels of taxation, regulation and stifling market intervention, and thus increasingly dependent on a constantly expanding fiat money supply and artificially cheap credit -is rapidly approaching ..”

    This “thus” needs some justification. IMHO it should say “the ever expanding social democratic ….”

    Do you agree?

    regards, Bob

    • says

      Yes, I am German. But I have lived in the UK for 15 years, I call London my home, and there is not much that attracts me back to Germany at present. I am sometimes not quite sure what I am, really.

      “the ever expanding social democratic state”….of course, that is correct. The welfare democracy is not built for retrenchment. This is something that may be said for every state. Every state is, per definition, the territorial monopolist of compulsion and coercion. It has the right to fund itself via taxation (expropriation) and it can make laws. Such an institution will never limit itself, and no constitution will ever limit it. It will constantly grow.

      Explaining the “thus”: The social democratic state is not an economically viable model. The constantly growing state apparatus and the growth in taxation and regulation weaken the productive private sector. Ultimately, the parasite kills the host. Over the past few decades this destructive trend has been masked through the constant expansion of fiat money: the state could constantly borrow cheaply and could constantly live beyond its means (income from taxation), while the loss in productive capacity as a result of taxation and regulation could be ‘compensated’ by a perennial boom in the financial sector and occasional asset bubbles. The credit party is now over.

  14. says

    “I am sometimes not quite sure what I am, really.”

    Well Detlev IMO you are a fine human being. Thank you for your work. To speak the truth about our political money in this time of politically induced disaster is beyond refreshing and helps reaffirm my own sanity.

    Please keep up your good Work!

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