Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown

 

Prologue

“Schlichter’s book is a terrifying window into our future. Every academic, politician, banker, and opinion former should read it now.”
–STEVE BAKER, Member Of Parliament for Wycombe

Mankind has used money for more than 2500 years. For most of history money was a commodity and most frequently gold or silver. There are good reasons why gold and silver have held this unique position. These precious metals possess some characteristics that make them particularly useful as monetary commodities, such as homogeneity, durability, divisibility and, last but not least, relative scarcity. The supply of these metals is essentially fixed. Gold and silver can be mined but only at considerable expense. Their supply cannot be expanded quickly and inexpensively. For most societies throughout history, the supply of money was therefore essentially inelastic.

Today we use money that is very different from what the vast majority of our ancestors used. Today money is nowhere a commodity. It is everywhere an irredeemable piece of paper that is not backed by anything. We live in a world of ‘paper money’, although most money today doesn’t even exist in the form of paper. It only exists as a book entry. It is electronic money or computer money. It is immaterial money. And because it is immaterial money, its supply is entirely elastic. Those who have the privilege of legally creating this money can produce unlimited quantities of it. Although human history and the growth of civilisations took place for the most part on the basis of inelastic money, modern societies around the world are now running their economies on perfectly elastic money.

Most people today do not appear to see a problem with this. Paper money works. We are all users of money, which today means users of paper money. Every day others in society accept our paper money (or electronic money) in exchange for goods and services. It evidently does not matter that these paper tickets or bits on a computer hard-drive are not backed by anything of real value or anything material at all. They constitute money because others accept them as money. Indeed, the idea that we could conduct economic transactions with heavy gold or silver coins appears atavistic and outdated. Today we pay increasingly electronically or by using our credit cards. Obviously, this constitutes progress. Nobody is surprised that money has changed so fundamentally. Compared to previous societies we are richer and economically and technically more advanced. No wonder that we use a different and more sophisticated monetary infrastructure.

However, this view tends to confuse innovations in payment technology with the basic construction of a monetary system. Even back when money was essentially gold, people often used money substitutes for payment purposes. Private banks issued banknotes that were used by the public in lieu of physical gold because they were more convenient to handle. As long as these banknotes were backed by gold in the banks’ vaults, they did not constitute paper money but were in fact commodity money. In principle, a society can use banknotes, electronic money transfers and credit cards and still be on a strict commodity system, such as a gold standard. As long as every quantity of money is fully backed by gold or some other commodity in a vault, the supply of money is essentially inelastic and the economy on a commodity standard. The public simply uses various technological devices to transfer ownership of the gold money.

The question is not whether modern payment techniques, such as credit cards and wire transfers, constitute progress – they undoubtedly do – but whether the shift from inelastic commodity money to fully elastic immaterial money constitutes progress. Why has the world moved from inelastic to elastic money? Is this because of some overwhelming advantages? If so, what are they? Do economies function better with elastic money than with inelastic money? Can economies grow faster if the supply of money is not restricted by the scarcity of some commodity but if it can be constantly and flexibly expanded?
Probably, most people will intuitively answer the last question in the affirmative. It seems logical that a growing economy, in which constantly more goods and services are being produced and constantly more transactions occur, more of the medium of exchange is needed. A growing supply of money seems to most people to be the natural corollary of a growing economy.

Surprising as it may sound, this is actually not the case. A growing economy does not need a growing supply of the medium of exchange. It is indeed in the very nature of a medium of exchange that – within reasonable limits – practically any quantity of it is sufficient to accommodate any number of transactions. An economy does not need more money to produce and trade more goods and services, to become more productive and to generate wealth. Only a conceptual and systematic analysis can prove this conclusively. Such an analysis will be part of this book.

But even before we conduct such an analysis it should be fairly clear that the notion that elastic money is required for a growing economy is rather unconvincing. Obviously, human societies have made great advances throughout history while using practically inelastic commodity money. The Industrial Revolution occurred in what was basically a commodity money environment. Between 1880 and 1914 most of the developed world was on what came to be called the Classical Gold Standard. This was a time of rapidly growing international trade, of rising living standards and stable and harmonious monetary relations between states.

Additionally, a quick look at present monetary arrangements with their fully elastic money supply reveals that a growing supply of money does not even require a corresponding growth in demand for money. Today’s paper money can be created and placed with the public whether there is demand for it or not. This may affect the purchasing power of the monetary unit but lack of demand is no obstacle to a growing supply.

Ben Bernanke, before he became chairman of the world’s most powerful central bank, the U.S. Federal Reserve, expressed it with commendable clarity:

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost…We conclude that under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

It would be naive to assume that today ever more money is being produced because there is growing demand from the public for it. Instead, we may reasonably ask what comes first in our economies with their perfectly elastic money: is the constantly expanding supply of money the outcome of economic conditions or are economic conditions the outcome of the constantly expanding supply of money?

Mr. Bernanke made the above remarks in a speech about a specific economic situation, namely the potential threat of deflation and how the Federal Reserve may counter this threat. However, by controlling the supply of money the central bank has enormous influence over the economy at any time. Central banks such as the U.S. Federal Reserve do not expand the money supply only at times of crisis. The supply of money is expanded constantly, usually in accordance with politically defined goals, such as a certain rate of economic growth, levels of unemployment and moderate inflation. Money creation in our present financial system is not the natural outcome of the market and the spontaneous interaction of members of the public but a governmental tool for shaping the conditions of the economy. Injections of new money always change economic processes and these money injections occur today almost constantly. Sometimes the money supply is expanded faster and sometimes more slowly, but in principle, the money supply is expanded all the time. The money producers tell us that they have good reasons for this policy, but if these reasons turn out to be faulty or inadequate the unintended consequences for society overall will be enormous.

Giving such extensive powers over the economy to political authorities would have appeared inconceivable to most previous societies. Indeed, one of the attractions of gold and silver as media of exchange throughout history was that their supply was essentially outside of political control. The fact that money today exists everywhere exclusively as a territorial monopoly of the state may tell us more about the changed attitudes of the general public towards state power than about the necessities of a modern economy.

 

Two of the commonly given reasons why state-controlled paper money is better than commodity money are that by controlling the money supply the central bank can provide a monetary unit of stable purchasing power as a reliable basis for economic calculation, and that the central bank can at times of crisis support the economy with extra money injections. As popular as these notions may be, both fail the test of history and theory dismally. It is simply a historic fact that commodity money has always provided a reasonably stable medium of exchange, while the entire history of state paper money has been an unmitigated disaster when judged on the basis of price level stability. Replacing inelastic commodity money with state-issued paper money has, after some time, always resulted in rising inflation. Indeed, the historical record is so unambiguous on this that any suggestion that paper money provides greater stability than commodity money borders on the ridiculous. Historically, exactly the opposite has been the case. It is equally a fact of history that at no point was paper money introduced in response to the demands of private citizens for a more stable monetary unit. History knows no incident of commodity money being replaced by a full paper money system purely on private initiative. By contrast, many states over the past 1000 years have imposed state-issued paper money on their populations, always for the purpose of funding the government, most frequently to finance a war.

It is true that commodity-money economies have a tendency to experience moderate secular deflation. In an economy in which the supply of money is fixed, the production of additional goods and services must lead to lower prices over time. But this type of deflation does not pose an economic problem. Quite to the contrary, it has many advantages. The type of deflation that Mr. Bernanke, in the quote above, promises to avoid with potentially unlimited money creation is of an entirely different nature. It is a crisis-phenomenon that occurs in an economy that suffers from excessive levels of debt and inflated asset prices. Such an economy must sooner or later experience a deflationary correction. But excessive debt and asset price bubbles are inconceivable without a previous extensive credit boom, which in turn can only result from excessive money creation. Those who argue that ‘elastic’ money is a blessing because we can counter deflation and depression, overlook the overwhelming evidence that it is elastic money that is predominantly responsible for creating the dislocations that make a deflationary depression a risk in the first place.

Eminent economists explained long ago why an expanding supply of money is a source of economic disturbance. The British Classical economists of the so-called Currency School (David Ricardo, Lord Overtone, and others) demonstrated this in the middle of the 19th century. But it was the economists of the Austrian School of Economics, in particular Ludwig von Mises and Friedrich August von Hayek, who from 1912 to 1932 developed this insight into a fully-fledged theory of the business cycle. This theory is known today as the Austrian theory of the business cycle. Although it is probably the most compelling theory of economic fluctuations in modern times, it did not obtain a prominent place in the developing macroeconomic mainstream of the 20th century. The mainstream was shaped by Keynesianism and later Monetarism, schools of thought that, despite their ideological differences, both embrace state-issued elastic money.

The British Currency School economists and the ‘Austrians’ developed their theories under gold standard conditions. The ‘elasticity’ of money that they were concerned with was different in certain respects from money’s elasticity today. It was mainly the result of banks issuing banknotes or creating bank deposits that were not backed by physical gold, a practice that became known as ‘fractional-reserve’ banking and that was frequently encouraged by governments, mainly through their state-owned central banks. An expansion of the money supply, in this case through ‘fractional-reserve’ banking, causes interest rates on the market for loans to drop and more credit to become available. This initiates an investment-led boom at first. However, overall investment activity now exceeds voluntary saving in the economy. As the Austrian economists demonstrated conclusively, the long-term consequences of an investment boom are very different depending on whether it was financed through proper saving or money printing. The mismatch between investment and saving in the latter case must ultimately transform the boom into a bust. Without the resources that only voluntary saving can make available the new investment projects cannot be sustained. It becomes apparent that resources have been misallocated in an artificial, money-induced boom. The inevitable reallocation of resources and relative prices occurs in the following recession.
The recommendation from the British and Austrian economists was clear: if you want to avoid recessions you must avoid artificial investment booms generated by cheap credit. Stick to a proper gold standard and restrict the practice of ‘fractional-reserve’ banking! In other words, make money less elastic! Since the early part of the 20th century, however, a very different policy has been pursued.

The U.S. Federal Reserve (Fed) is the central bank of the world’s biggest economy and the provider of the world’s leading paper currency. It was founded in 1913 specifically as a lender-of-last resort for Wall Street. Its purpose was not to restrict credit-growth and the balance-sheet expansion of Wall Street banks but to encourage and support it. The Federal Reserve was instrumental in extending the credit-driven boom of the 1920s that set up the economy for the Great Depression. Many modern supporters of paper money and central banking consider the Fed’s response to the crisis inadequate, as they would have liked to see a more aggressive injection of additional money. They focus their criticism on the Fed’s role in crisis management but not on the Fed’s role in the formation of the excesses that made a major crisis inevitable in the first place. In any case, the following decades saw further institutional changes to the monetary infrastructure designed to facilitate more money creation, to make the currency more elastic. In 1933 President Roosevelt took the United States off the gold standard domestically. A tenuous connection to gold was sustained for a few decades after World War II, but in 1971 President Nixon took the dollar off gold internationally, too. Most other currencies had already severed direct links to gold and had only maintained an indirect one through the dollar as the global reserve currency. Since 1971, the entire world has thus been on a paper money standard for the first time in history. Money can now be created out of nothing, at no cost and without limit.

When money was ultimately still gold, money-induced business cycles used to be fairly short, although still very painful. The credit boom was limited by the inelasticity of bank reserves. When banks had lowered reserve ratios too much, they had to cut back on new lending, and when this occurred nobody could provide extra reserves to the banks and thereby extend the credit boom further. By the same token, nobody could soften or shorten the inevitable recession, which was therefore allowed to unfold unchecked and thus cleanse the economy of the capital misallocations of the preceding false boom more or less completely. All of this changed with the introduction of unlimited state paper money and lender-of-last-resort central banks. Naturally, in this new system the money supply is still expanded and interest rates are still artificially lowered to encourage extra investment. As a result, capital misallocations still accrue. Investment and saving still get out of synch and the economy overall still becomes unbalanced. But the recessions – still needed to cleanse the economy of dislocations from the artificial booms – are now supposed to be avoided or, at a minimum, shortened through additional injections of reserve money whenever the economy rolls over. In a system of elastic money, credit cycles are being extended considerably, which means that the price distortions and resource misallocations become much bigger over time.

The inevitable consequences of the new infrastructure and policy become ever more manifest. Since 1971 the decline in the purchasing power of pound and dollar – two of the oldest currencies in the world – has been the steepest in their long history. Debt levels have risen sharply and the financial industry has greatly expanded. As economists Carmen Reinhart and Kenneth Rogoff demonstrated in their extensive study of financial crises, the number and intensity of international banking crises has risen markedly since 1971. Japan experienced an enormous money-driven housing boom in the 1980s and has still not recovered from the dislocations this created. The United States and Western Europe (with the exception of the Scandinavian countries) have, until recently, escaped major crises. This does not mean that the economies have not accumulated money-induced dislocations. In the case of the U.S. in particular, it only means that the monetary authorities managed to repeatedly extend the credit boom through timely rate cuts and additional money injections whenever a recession began to unfold.

The last time U.S. authorities allowed high real interest rates to cleanse the economy of the accumulated misallocations of a preceding inflationary boom was in the early 1980s. Since then, money- and credit growth were, by and large, allowed to resume and even actively supported, not least because, since the late 1980s, most of the monetary expansion was channelled into financial assets and real estate. As the new money mainly lifted the prices of stocks, bonds and increasingly houses, and as the ongoing but comparatively moderate price increases in the standard ‘consumption basket’ were judged to be acceptable, money-fuelled credit expansion was tolerated and actively supported by the central bank. Since the late 1990s the Fed has on various occasions successfully extended the credit boom: in 1998, when the collapse of hedge-fund LTCM and the default of Russia threatened to kick off a wave of international deleveraging; towards the end of 1999, when the Fed injected substantial amounts of money prohibitively out of concern about potential computer problems related to Y2K; between 2001 and 2004, after the Enron and WorldCom corporate failures and the bursting of the NASDAQ bubble, when the Fed left interest rates at one percent for three years.

As one should expect and as is now abundantly clear, the credit excesses and mispricing of assets have reached phenomenal proportions. In the ten years to the start of the most recent crisis in 2007, bank balance sheets in the United States more than doubled, from 4.7 trillion dollars to 10.2 trillion dollars. The Fed’s M2 measure of total money supply rose over the same period from less than 4 trillion dollars to more than 7 trillion dollars. From 1990 to 2009, U.S. mortgage debt quadrupled from 2.5 trillion dollars to over 10 trillion dollars. From 1996 to 2006, U.S. house prices appreciated, in inflation-adjusted terms, three times as much as over the preceding one hundred years.

It seems undeniable that elastic money has not brought greater stability. Regarding the stability of money’s purchasing power, the historical record of paper money systems has always been exceptionally poor. But it is now becoming increasingly obvious that the global conversion to paper money has also failed to put an end to bank runs, financial crises and economic depressions. Quite to the contrary, those crises appear to become more frequent and more severe the longer we use fully elastic money and the more the supply of immaterial money expands. Astonishingly, an established body of economic theory does exist that explains with great clarity and precision why this must be the case: the Currency School of the British Classical economists and, in particular, the Austrian School of Economics. Their insights, however, remain strenuously ignored by the academic mainstream, the policy establishment and the majority of financial market participants.

At this point a few personal notes from the author may be in order: Before I set out to write this book I spent nineteen years as an investment professional in the financial industry. This has given me extensive exposure to the intellectual frameworks and the accepted belief systems that dominate financial market debate. To make sense of what happens around us, we all need a set of theories that function as a prism through which we view, order and try to understand the phenomena of the real world. These theories are usually not the object of inquiry themselves. They are the indispensible tools of inquiry and thus presumed to be essentially true. I found that in financial markets it is indeed a very limited set of theories and concepts that provide the commonly shared framework. These concepts are mainly derived from what became, in the 20th century, the popular strands of macroeconomics, mainly Keynesianism, the neoclassical school and monetarism. All of them embrace active government involvement in monetary affairs, and the willingness to challenge these doctrines is remarkably low. What increasingly amazed me over the years was the following: although the dislocations of ongoing monetary expansion were becoming ever more palpable – the ever higher debt levels, the asset price bubbles and the wide-spread addiction to cheap credit – the very viability of a fully elastic paper money system itself was never seriously doubted. The idea that a system of elastic paper money is superior to a system of inelastic commodity money continues to command the status of unquestionable truth. As the dislocations and instabilities of the present system are getting bigger every year and ever harder to ignore, the mainstream still tries to explain them away by referring to unrelated external shocks, such as ‘excess savings’ in Asia or increased international capital flows, or interprets them as the result of occasional policy mistakes, of the inappropriate handling of what is still believed to be a superior policy tool kit. The question that is not being asked but should be asked is, whether all the apparent problems are not due to the inherent instability of paper money. What if elastic money is always inferior to inelastic commodity money, as many eminent economists of the past asserted with apodictic certainty? This is the question I want to address with this book.

It is apparent that most commentators, politicians and central bankers do not want to give up the comforting belief that the government can always fix the economy with injections of more money. They want to share Mr. Bernanke’s confidence “[...]that under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” This, however, may mean covering up the symptoms of the crisis and postponing it while, at the same time, making the underlying problems even bigger. It also means that ever more money needs to be injected to buy the system time and to manufacture another round of money-induced and thus temporary growth. Ultimately, this must undermine the public’s confidence in state paper money. Without this confidence, immaterial money has nothing to fall back on, nothing that gives it a back-stop of real value. The endgame is not the self-sustaining growth that policy-makers promise the public, but complete currency collapse.

We have already reached a point at which ever more extreme measures are being taken. Over the two years following the collapse of investment bank Lehman Brothers, the Fed expanded the part of the money supply that it controls directly – bank reserves and the monetary base – by more than 1 trillion dollars, thus creating more money of this type than the Fed had created in aggregate up to this point since its inception in 1913. Ever larger sums of money are increasingly needed to simply keep the overstretched credit edifice from collapsing. The Fed used the new 1 trillion dollars to take large chunks of toxic assets that had accumulated on bank balance sheets as a result of bad lending decisions during the preceding boom onto its own balance sheet and thereby prevent the banks from selling them into the market. The prices of hundreds of billions of financial securities are thus being artificially propped up to avoid the market from revealing the lack of true private demand for them. Money printing may be costless to the Fed. Whether such a strategy is costless to society is a different question.

Is a system of elastic money superior to one of inelastic money? This was the question we started with. But as we are beginning to investigate the apparent fault lines of the elastic money system the question becomes a different one: Can a system of elastic, state-controlled paper money be made to work at all? Is the elasticity of the money supply that is the defining feature of a paper money system, not ultimately the cause of its undoing? If an expanding supply of money is always a source of disruption, if money injections always distort relative prices and disorient market participants, then every paper money system must sooner or later encounter business cycles. If the paper money producer – ultimately always the state via its central bank – counters the recession with additional money production this must compound the underlying dislocations. The central bank can – for some time at least – engineer recoveries but only at the cost of additional misallocations of capital and mispricing of resources. Stronger growth through money injections is always transitory. The next recession will definitely come and be more severe than the previous one. The only lasting effect will be that the economy becomes progressively more unbalanced and ever more dependent on artificially cheap credit and ever more new money.

This process cannot last forever. What is the endgame?

In 1949, Ludwig von Mises stated it thus: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

All paper money systems in history have failed. Either the paper money experiment was abandoned voluntarily by a return to inelastic commodity money or involuntarily and violently by the inflationary meltdown of the monetary unit with dramatic consequences for economy and society. No complete paper money system has survived.

China invented paper, ink and printing and was thus the first to experiment with paper money, probably as early as around 1000 AD. Between the early 12th and the late 15th centuries, extensive paper money systems were developed under the Southern Song Dynasty (1127-1279), the Jin Dynasty (1115-1234), the Yuan Dynasty (1271-1368) and during the early period of the Ming Dynasty (1368-1644). In all cases state paper money was issued to raise revenues for the state. After some time, all dynasties experienced inflation and, indeed, progressively rising inflation until their paper monies became worthless. This coincided with the collapse of the respective dynasties or their demise through conquest. Only the Ming Dynasty escaped this fate via a timely return to commodity money. After 1500 no paper money was used in China. It was only reintroduced in the 19th and 20th century as part of Westernization.

The early Chinese experience was repeated with remarkable regularity in the Western world. Failed paper money regimes include the ones in Massachusetts and other North American colonies from 1690 to 1764, France from 1716 to 1720, the North American colonies again around the time of the American War of Independence, from 1775 to 1781; France again from 1790 to 1803, Germany from 1914 to 1923. The 20th century was the century of state power, of totalitarian regimes, of socialism, communism and fascism, and two World Wars. It was also the century that was ideologically most opposed to commodity money and most willing to entrust control over money to a “determined government”. Not surprisingly, it is the century with the most currency disasters. Economic statisticians define a hyperinflation as a monthly rise in consumer prices of fifty percent or more. On this definition, the 20th century saw 29 hyperinflations.

Currencies like the North American continentals, the French assignats and the German reichsmarks have come and gone. Pound and dollar have survived and are now the oldest currencies in use but this is because for most of their history they simply represented specific units of an underlying inelastic commodity. Whenever they were taken ‘off gold’ or ‘off silver’ – the pound, for example, during the Napoleonic Wars or the dollar during the American Civil War – they also experienced rising inflation. Their demise was only averted by a timely return to inflexible commodity money.
The history of paper money systems is a legacy of failure. Without exception paper money systems have, after a while, led to economic volatility, financial instability and rising inflation. If a return to inelastic commodity money was not achieved in time, the currency collapsed, an event that was invariably accompanied by social unrest and economic hardship. But no matter how devastating the historical record, the paper money idea is always revived. It has resurfaced most spectacularly towards the end of the 20th century.

This book investigates the feasibility of paper money systems. It aims to show conclusively that an economy cannot be stable if it uses a form of money the supply of which is flexible and, on trend, expanding. Injections of new money always distort market prices, disorient market participants and lead to misallocations of resources. Money is never neutral. It can never just be an economic fertilizer that stimulates every kind of economic activity without altering economic structures.
The mainstream view today is that a zone of harmless money production exists. Therefore, if money creation is handled astutely by the central bank, society can reap the benefits of lower interest rates and cheap credit without suffering the disadvantages of economic instability and inflation. This book argues that this view is wrong. Every form of money injection will lead to disruptions. Additional growth as a result of money injections is always bought at the price of underlying dislocations that must disrupt the economy later. This is true even if the money injections occur at times of low or even negative inflation or at times of recession.

Elastic money is superfluous, disruptive, destabilising and dangerous. It must over time, result in growing imbalances and economic disintegration to which the proprietor of the money franchise – the state – will respond with ever larger money injections. When the public realises that a progressively more unbalanced economy is only made to appear stable with the temporary fix of more money, it will withdraw its support for the state’s immaterial monetary unit. A paper money system, such as ours today, is not only suboptimal it is unsustainable. And the endgame may be closer than many think.
Such a drastic statement can, of course, not be based purely on the historical record, no matter how strongly supportive the experiences with paper money are of the case we are making here. History can only ever tell us what happened, never what must happen. Our case has to be built on theory. And here, we can construct our argument with considerable help from some of the greatest minds in economic science, from the great British Classical economists to Menger, Mises and Hayek of the Austrian School of Economics. One social scientist will be of particular importance: Ludwig von Mises, whose seminal work on money and business cycles forms the basis of much of our theoretical argument. To a considerable degree our job will be to make Mises’s contributions relevant for our present monetary infrastructure and to use his insights to expose the widespread misconceptions of today’s mainstream. We will start our theoretical analysis with some basic premises that the reader -as a user of money – can easily test for himself or herself. All other insights will be arrived at through careful logical deduction. Only through such a process can we reach universally valid conclusions. This process also allows readers who have no background in economics to follow our argument.

The book is divided in 5 parts. Part one establishes some basic facts about the origin and purpose of money and money’s unique characteristics, in particular as they relate to demand for money. We will see how changes in the demand for money are satisfied in a system with commodity money of essentially fixed supply. We will also elaborate the key procedures behind ‘fractional-reserve’ banking and see that this practice did not originate from additional demand for money and that it is indeed unrelated to changes in money demand.

Part two is in many ways the core of the book. By way of a theoretical analysis that starts with very simple models of money injections and, step-by-step, takes us to more complex and realistic models of money injections we will show that money injections must always disrupt the economy. Today’s mainstream view is that money injections lift ‘spending’ and ‘inflation’. We will see that this is basically correct, at least initially. But we will also see that every injection of new money must have many more sinister effects, in particular on relative prices and resource allocation. The widespread idea that controlled and moderate money injections can be harmless and even beneficial will be refuted.

Part three addresses some common fallacies about price level stability as an indicator of monetary stability and as a goal for monetary policy. We will see that the notion that elastic paper money can be made to be stable in terms of its purchasing power is theoretically flawed and impossible to realise in practice.

Part four provides a brief history of paper money systems. This section illustrates that they were always introduced by state authority and with the aim to finance government expenditure, most frequently to fund wars. All paper money systems have experienced rising inflation and financial instability, frequently leading to currency collapse.

Part five deals with the approaching demise of the present paper money system. This part starts with an analysis of the intellectual foundations on which present arrangements and present policy rest. The belief in the feasibility and desirability of state-controlled elastic money is so widespread and deeply ingrained today that the policy response to growing money-induced imbalances will not only be inappropriate, it will be counterproductive and ultimately accelerate the disintegration of the present system. We will see how this process is most likely going to unfold. This is, by definition, the most speculative part of our analysis, although the number of possible endgames is decidedly limited.

That the present system must end, like all preceding paper money systems ended, is without question, and it looks increasingly as if it will end badly. There are only two options. Either societies abandon the concept of unlimited money from nothing, allow the full and undoubtedly painful liquidation of previous capital misallocations and return to inflexible commodity money, as has been done many times in the past, or we will experience a catastrophe in form of a complete collapse of our monetary system as has also happened many times before. Sadly, the latter scenario appears much more likely at present. We are likely to witness ever more aggressive money injections by the central banks in order to keep interest rates and risk premiums at artificially low levels, to keep the overstretched credit-edifice from collapsing and to sustain the mirage of solvency of state and banks. When the public finally grasps the full implication of this, confidence in the system will evaporate quickly. The endgame will be high inflation and total currency collapse.

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