Modern Money – Part II: Harvey Dentby Menachem Sahler (@UraniumFarmer)
Does the government devalue your currency so that it always has control over you? Is the USD truly “unbacked”? Do fiat currencies even exist? When does an economic contraction happen?Those are some of the questions that will be answered in this article.
In Part 1, I described the basics of how money comes to exist as a result of commercial loans being originated by banks.
In this part, I’ll continue the discussion with some of the top-of-mind implications of the monetary system.
I think that one of the most important realizations to take from this money creation process is that money does not exist independently; but rather only as the counterpart to debt. Money and debt are two sides of the same coin. Furthermore, because of the repayment property of debt, money exists on a time dimension as well, and not as the static store of value so many want, expect, or believe it to be.
TLDR:
1. Money does not exist on its own. Money is the counterpart to debt. Debt & money only exist together.
2. Governments do not create money. They borrow it from you when they need it. Commercial banks create money.
3. The USD is not “unbacked”, it is not a “fiat” currency. Each unit of currency was created as part of a debt covenant. It’s backed by the collateral that banks require before they create money. The reason why the USD hasn’t failed yet, is because of the strength of motivation that borrowers have not to default on their loans and loose their collateral. That is, by definition, a type of backing.
4. What about credit cards? They’re often not backed by collateral, right? True. However, even money without explicit physical collateral backing is still backed by the borrower’s motivation to avoid default, the collections process, credit rating demotions, and legal penalties that may follow.
5. The current economic system assumes a continued expansion an increase in the value of the collateral, without which a bankruptcy is not imminent, but is inevitable.
6. How each loan impacts the monetary system is complex to model, but is most heavily influenced by when the debt originated, the maturity schedule (duration), interest rate, and if it ever gets refinanced or repaid, and whether it gets repaid by savings or the cash flows that may originate from an income-generating asset.
7. The process of assessing collateral higher followed by money supply increasing at correspondingly higher rates is a circular feedback loop.
8. As long as the money that’s created by commercial banks is invested in increasing the overall value of the collateral, there is no problem even if the money supply grows by an infinite %.
Backing
Also noteworthy is that while there is much preoccupation with the lack of backing of so-called fiat money, this notion is largely based on the incorrect perception that governments actively debase the value of money by “printing” and subsequently spending it. The reality of the matter is that government spending occurs after they borrow money from the public, through issuing debt. Their effect is to extract money which has already been created in the economy through commercial banks originating loans, and then to redirect it. They simply do not create money. Weather or not this aspect of the monetary system ever changes, as per Modern Monetary Theory, is another matter entirely ⇀ a debate that is predominantly a political discussion, not one of our current monetary reality.
When a customer of a bank applies for a loan, they must generally post collateral. They must also pay a down payment. In most instances, the bank will not issue a loan in an amount that exceeds the assessed value of the collateral plus the down payment. Unless they are a predatory lender, the bank’s motivation in issuing a loan is simply to collect the interest payments. The reason for the collateral and down payment is to ensure that if the borrower defaults on the loan, the bank has legal grounds to liquidate the collateral and attempt to recover the loan amount owed.
From here, it’s a very logical step to understand that money, the counterpart to debt, is backed by the banks’ ability to collect the collateral in the event of default. Arguably much more powerful is the borrowers’ motivation to avoid delinquency which risks their losing some or all of their collateral (or equity in the collateral) and their down payment along with their sunk cumulative principal plus interest payments up to that point.
Similarly, the bank is motivated to only issue debt that is having adequate collateral value to more than offset any impairment due to the borrower defaulting, or to be very careful to issue the debt to borrowers who they’re confident in repaying the debt, or some combination thereof. Of course, if the bank does a bad job of managing their loan risks, or a bad job of assessing collateral value/liquidity, they may find their balance sheet impaired after a borrower defaults.
Next time you hear someone saying anything along the lines of “fiat is backed by nothing”, hopefully you’ll at least approach their claims with skepticism. They are likely simply unaware that money is backed by the powerful motivation of borrowers and lenders to avoid defaults. Major modern currencies are in essence not at all fiat currencies to begin with. Each unit of currency was created as part of a debt covenant.
It is true that some debt does not come with such constraints. Top of mind is lines like credit card debt which require no collateral posted from the borrower and, of course, there is normally no down payment for the line of credit either. In these cases, the bank is taking higher risk of default in exchange for much higher interest rates and fee income. However, most anyone who has had the unfortunate experience of defaulting on credit card debt knows full well how unpleasant the banks will try to make the experience for the borrower. They still have legal claims against the borrower even though there was no collateral posted. In full effect, even money without explicit physical collateral backing is still backed by the borrower’s motivation to avoid default, the collections process, credit rating demotions, and legal penalties that may follow.
Expansion
With a basic understanding of how money comes into existence, naturally backed by the powerful motivation of avoiding losses for both loan counterparties, it’s worth considering how supply expands and contracts in aggregate. As described in the introduction, the total supply and demand for money will heavily influence economic productivity.
Consider again the baseline scenario of a theoretical virgin economy where no money exists yet. Someone applies for, and is granted the very first loan, bringing useful money into the system, which in turn facilitates commercial transactions. Because the loan has a finite payment schedule and an above-zero interest rate, the borrower must procure more money than they initially borrowed across the duration of the loan. However, with each payment period, both sides of the bank’s balance sheet shrink by the amount of repaid principal; the money created by the loan is gradually extinguished from existence at an accelerating pace. With each payment, the bank retains the interest portion of the payments as part of their revenue. As the loan matures, eventually, no matter the commercial prowess of the borrower, they will ultimately be forced into insolvency as there will be not enough money left in this single-loan system to meet the payment schedule. While default is perhaps technically avoidable without further money creation, it would require the bank to have no cost of revenue which might be retained anywhere, spend their entire revenue back into the economy, and for that borrower to somehow extract every bit of money from the system to meet their final debt payments at loan maturity.
But economies are messy, complicated, and unpredictable; money gets saved and sometimes lost. In a practical sense, the only means to avoid this forced debt default is for new loans to be created during the term of the initial loan, which brings new additional money into the system. The original borrower can then have a chance to earn enough of that new money in the economy, created by the subsequent loans, to meet their payment obligations.
The future layering in of new loans in the monetary system is an implicit assumption that both the borrower and lender make. Without that expansion of total systemic debt, bankruptcy is not imminent, but is inevitable. Without expansion, one or both parties would eventually end up worse off as defaults occur and collateral gets liquidated.
Assuming new loans are originated during the duration of the initial loan, they each impose their own initial inflationary contribution to money supply and subsequent deflationary “demand” on the larger, but still limited money supply. Each new borrower is effectively fighting for the same pool of money to avoid their own delinquency, and they are in aggregate relying on the systemic debt level to continually rise exponentially. From here, it’s easy to see that the expansion in debt goes hand in hand with the expansion of money supply, both being “a feature and not a bug” of the system.
Each new loan has the effect of initially relieving some of the demand for money in the system, but only until it eventually matures to a point where the demand from principal and interest payments outweigh the initial introduction of additional new money. How each loan impacts the monetary system is complex to model, but is most heavily influenced by when the debt originated, the maturity schedule (duration), interest rate, and if it ever gets refinanced.
If credit does not expand, in other words new loans are not issued, rapidly enough, this can create money scarcity which can force insolvency if there’s not enough to service the legacy debts, a potentially contagious condition. For the monetary system to run smoothly, new credit must be issued at a rate that at very least provides enough money to meet the payment schedule of aggregate loan payments. Furthermore, this is not even considering the frictions such as low velocity which can act to negate the effect of new money supply ⇀ if someone is granted a loan, but chooses not to spend the money into the economy, they’re effectively adding to future money demands (they must still pay interest), but opting not to contribute to current supply.
Similarly, avoiding future defaults requires the debt must ultimately be used to increase collateral values in the economy (i.e used productively, like borrowing money to build a business). If the debts are squandered and the total systemic value of collateral does not rise, or if it falls, this will constrain the ability for new loans to be issued at an accelerating rate.
The rate of monetary expansion, even when banks are very willing to lend, is directly linked to the free markets. The main numerical input for loan size is how collateral is assessed. In some sense, when a bank grants a loan, they assess the collateral at prevailing market rates (perhaps along with some risk premium built in), but ultimately the particular numerical value of the collateral is arbitrarily determined by the market, not the bank. For example, what causes a house to be assessed at $500,000 instead of $5,000? It’s mostly from looking at other similar houses nearby. If the market thinks collateral is worth more than last year, then the bank is likely to assess it higher as well, as they look to comparable property transactions for reference. When the bank issues a new loan to someone applying for a larger mortgage on that house, they will increase the money supply by a larger amount than if that same mortgage was granted some time prior, at a lower housing market baseline.
This process of assessing collateral higher followed by money supply increasing at correspondingly higher rates is a circular feedback loop. The rate of money supply growth may be self-referential, with a natural bias towards exponentially higher rather than lower numbers, since collateral sellers tend to demand some capital gains in order to agree to a transaction. Of course this should be taken only in a very general sense, but perhaps holds because the dominant form of collateral (excluding debt itself) is real estate. Other large-ticket assets such as vehicles, machinery, and built infrastructure have collateral values that decline toward their scrap rates. Note that while something like a passenger car may be used to collateralize its own consumer auto loan, such debts represent a small portion of total new money supply relative to real estate backed loans. That being said, there is certainly not a lot that is mechanically stopping an unwind and reversal if collateral price momentum of real estate falters.
This post continues in Part 3.
Please read this, it really is important and for your own good:
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