“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
— John Maynard Keynes
“The process by which banks create money is so simple that the mind is repelled.”
— John Kenneth Galbraith
In the midst of what many Americans understand to be a modest, though genuine, recovery from the Great Recession officially dated from December 2007 to June 2009, there remain enough lingering indicators of recession, from chronic unemployment to falling home prices, to alarm all but the most politically compromised economic pundits. While the financial crisis that punctuated this Great Recession becomes better understood through a spate of recent books and one compelling documentary, in my opinion there remains a widespread lack of appreciation for the root cause of the crisis and the continuing crisis-potential it presents. I presented my concerns about the crisis-potential in the US economy in a host of articles written from 2002 to 2006, one of which, entitled Debt Trap, explained in the simplest terms possible a fundamental flaw in the design of our monetary system for which there is no inherent fix and no easy exit.1 2
The Monetary Debt Trap
From 1971 through 2010, the total debt in the US economy—Total Domestic Debt—has grown from $1.7 trillion to $50.5 trillion, with an average annual growth rate of 9.2%. This remarkably high rate of debt accumulation is well above the 6.9% average annual growth rate in the inflation-saturated Nominal Gross Domestic Product, which grew from $1.1 trillion in 1971 to $14.7 trillion in 2010. Thus, even fully inflated economic growth has not kept pace with the growth in debt over the past 40 years. What this means, on the surface, is that the debt accumulated by all the sectors in the US economy—governments, businesses, and households—is getting progressively more difficult to service by the annual income we are all producing, regardless of whether the economy is in recession or expansion.3 4
While it has become clear to most economic observers that the US and many other developed economies face an overwhelming debt burden, it is far more important to understand why debt has been relentlessly accumulating at a rate beyond that of fully inflated economic growth. The reason is to be found in the design of our currency. The US dollar, like all national currencies these days, is a debt-based currency created, not by the government’s printing press, but through the extension of credit from the central bank, via the fractional-reserve banking system, to borrowers in the government, business, and household sectors. As each new dollar is created, a new dollar of debt is also created, and as the supply of dollars accumulates over time, so too does the balance of debt.
How does the growth in debt-based money relate to overall economic growth? The answer to this begins with a closer look at what happens when new money is created. Each new dollar makes its first appearance as a new asset on the books of some bank and a new liability on the books of some borrower. But there's a catch. When new dollars are loaned into existence, they are recorded on the books of both the lender and the borrower, or creditor and debtor, as the principal amount of the loan. However, the interest that the debtor will have to pay back to the bank along with the principal is not created as part of the transaction. As everyone with a 30-year mortgage should know, the interest payments can be even greater than the principal payments over the life of the loan. Few people realize, however, that our entire monetary system is structured in a similar fashion, with the total supply of money currently in circulation being dwarfed by the total future debt service payments—both principal and interest—that must be paid by all government, corporate, and household debtors.
Where do these debtors find the additional dollars required to pay interest on their loans? In the existing supply of money already in circulation at the time of the loan, as well as any future net increases in the supply of money that precede each future interest payment. If the central bank holds the supply of money fixed from this day forth, then every debtor in the economy will be forced into a highly competitive zero-sum game to get what each one of them needs to make their debt service payments before the others get what they need. So the only way to ensure a sufficient supply of money to meet the demand of today's debtors is to systematically increase the supply of money each and every year in the future by an amount roughly equivalent to the average interest rate on all existing debt. This way there will be just enough money in circulation to ensure that just about every one of today's borrowers can get what he or she needs to pay principal and interest on their loans as it becomes due.
But there's another catch. The only way to increase the supply of money in the future is to extend additional credit and thereby create new debt over and above whatever debt is being repaid through principal payments. As we've seen, this brings with it the same constraint on future debt service, which means that the central bank will have to facilitate the creation of even more money for all the new debtors whose new loans are helping the old debtors pay their interest. So we take care of the older generation of debtors by creating a new generation of debtors who will suffer immeasurably unless the next generation of debtors fully participates in the system. Thus it continues, seemingly without end, until we have an economy so choked with old debt and so dependent on new debt that the most we can hope for is perpetual, debt-based growth in output that keeps pace with the perpetually growing debt service obligations of the entire monetary system.
Generally speaking, as central banks use the policy techniques at their disposal to promote perpetual economic growth—setting discount rates for their own lending to banks, setting federal funds rates for inter-bank lending, setting reserve requirements for banks' lending to households, businesses, and governments, engaging in open market purchases of government bills, notes, and bonds, and shaping people's perceptions of monetary policy and economic performance—they distort prices for borrowing, saving, production, consumption, employment, trade, and currency in unpredictable and unsustainable ways. Furthermore, the debt-based monetary system forces them to use all these policy techniques to achieve a sustainable rate of monetary inflation via credit expansion sufficient to provide enough money in circulation to fund the debt service obligations of the entire system. Finally, as this monetary policy is implemented through the profit-oriented fractional-reserve banking system, it results in progressively more complicated forms of credit creation inflating progressively more dangerous asset price bubbles—e.g., mortgage securitization and housing—the periodic deflation of which reveals the instability of this monetary system.
Therefore, the monetary system is designed with a built-in demand for an ever-growing supply of debt-based money that actually creates more inherent demand, enforced by an ever-growing threat of debt deflation should that supply fall too short of demand. As if defying this reality, central bankers must navigate an increasingly treacherous route between the Scylla of deflationary depression and massive debt defaults and the Charybdis of hyperinflation and currency collapse.
As dramatic as that sounded just five years ago, it is now a harsh reality that US monetary authorities at the Federal Reserve and Treasury are understandably loath to admit. The dark secret of their relatively successful era of economic growth, driven as it has been by the exponential growth in debt-based money, is that the returns on each new debt-based investment have diminished over time. Smoothing out the variability from one year to the next with rolling three-year changes, the trend is unmistakable: for the past 40 years, each new dollar of debt in our domestic economy—Total Domestic Debt—has yielded a decreasing amount of economic growth—Gross Domestic Product. For the three years that ended in 2009 and encompassed the Great Recession, the US economy generated just $0.11 of nominal economic growth for every $1.00 of additional debt.
Whether we call this ratio the marginal return on debt, the marginal velocity of debt-based money, or the marginal debt service capacity, it suggests that the capacity of this debt-based monetary system may have approached an absolute limit just as US monetary authorities were engaging in unprecedented efforts to prevent a total collapse of the financial system. In my opinion, the crisis was not limited to the mortgage securitization and credit default swaps markets or even the greater financial system of banks, insurance companies, and hedge funds considered Too Big To Fail. The crisis was, and still is, in our monetary system. With all due respect to Charles Ferguson, the debt-based monetary system is the real inside job, without which the Inside Job he profiled could not have been funded.5
As I wrote five years ago, we don’t have to wait for deflation or hyperinflation to arrive before we acknowledge our predicament. We are already caught in a system-wide debt trap with no easy exit. But we are not only debt trapped as a consequence of having borrowed beyond our means. We are debt trapped as a precondition for participation in our economy. We are debt trapped by design. Furthermore, because the dollar is a currency by fiat, we are also debt trapped by decree. By decree of the US federal government, we are all compelled to use this particular type of money. We have no choice but to participate in this opaque and unaccountable monetary system and by doing so we must accumulate debt, if not directly through our own households and businesses then indirectly through the local, state, and federal governments that borrow in our names and tax us for their debt service.
No easy exit, perhaps, but might there be a fix? Despite the alphabet soup of more-or-less complicated emergency responses—from the Treasury’s Troubled Asset Relief Program ("TARP") and Term Securities Lending Facility ("TSLF") to the Fed’s Zero Interest Rate Policy ("ZIRP") and Quantitative Easing ("QE")—it is far from clear whether US monetary authorities have done anything other than bail out the biggest bankers, artificially inflate the value of bad debts, and buy a couple years’ time to explore solutions to the deeper monetary crisis they certainly must recognize. I have wondered if the sheer messiness of their overall strategy is a deliberate effort to distract attention from the utter simplicity of the real problem and delay an even more debilitating phase in the unfolding of the crisis.6
All these emergency actions, together with the conventional monetary and fiscal policies used in every recession, can be arranged along a spectrum of interventions from forced to facilitated to permitted leveraging and then from permitted to facilitated to forced deleveraging. Where the items on each of our respective balance sheets show up on that spectrum determines the specific ways in which each of us is being helped or harmed by the recent actions of the Federal Reserve and Treasury. Regardless, as my six-fold repetition of the term leverage indicates, it’s all about the debt, which means it’s all about the monetary system that remains “unfixed” despite no shortage of emergency responses. With no easy exit and no inherent fix, what, then, is our monetary future?
Engaging Monetary Uncertainty
Frank Knight, the economist who founded the Chicago School, observed that “we live in a world full of contradiction and paradox, a fact of which perhaps the most fundamental illustration is this: that the existence of a problem of knowledge depends on the future being different from the past, while the possibility of the solution of the problem depends on the future being like the past.” The “problem of knowledge” to which he referred is the fundamental challenge faced by every human actor: uncertainty about the future. The solution to this problem is therefore to be found in our methods of engaging with uncertainty as an essential feature of human action.7
One of the best ways of engaging uncertainty begins with crafting a set of diverse, yet plausible scenarios for the future of our action context—in this case, the context of monetary policy and its market consequences. As a structured approach to engaging with the uncertainty of the future in light of the certainty of the past, the discipline of scenario thinking exercises an underdeveloped cognitive capacity that resides somewhere between:8
- the all-too-common tendency to assume, without much awareness, that the future will be a continuation of the past; and
- the all-too-rare capacity to be fully aware in the present, without regard for projected pasts and futures.
Crafting scenarios opens a cognitive space in which the presence of both past and future—relative certainty and uncertainty—can be articulated with sufficient clarity as to be actionable. The scenarios crafted may therefore be understood as actionable knowledge of alternative futures, while the crafting of scenarios is an ongoing practice of action-learning amidst alternative futuring.
When we consider our immediate economic future and the major role that monetary policy will play in shaping that future, we must begin with the fact that the monetary system itself constitutes a debt trap by design. The debt trap is the primary certainty we all must face. Even those monetary authorities who would seem to have the most power to shape our monetary future must still conduct their policy within the existing debt trap. Furthermore, the debt trap has evolved over many decades to its present status deep within what might be termed the crisis phase, which is also a relative certainty we cannot escape. Of course, knowledgeable people can interpret economic indicators in different ways and arrive at different conclusions about where we are in the unfolding of the monetary drama. The scenarios I present in this article are based on my own, admittedly incomplete, assessment of the present certainty of this context.
The primary uncertainties, for those of us outside the inner circle of policy-making, are the two general policy choices presented to monetary authorities in every nation, each of which presents a dynamic dilemma:
- Hard Money vs. Soft Money – Will they try to maintain a relatively strong or weak currency in relation to other currencies?
- Unilateral vs. Multilateral – Will they act in a relatively competitive or cooperative manner with their counterparts in other countries?
Crossing the two policy dilemmas creates a two-by-two matrix with four quadrants, each of which frames one scenario—one compelling, plausible story of the future—governed by a unique pair of policy orientations to the crisis phase of the debt trap:
- Monetary Reboot – a unilateral hard money policy and its potential market consequences.
- Monetary Crash – a unilateral soft money policy and its potential market consequences.
- Monetary Patch – a multilateral soft money policy and its potential market consequences.
- Monetary Upgrade – a multilateral hard money policy and its potential market consequences.
These are the same basic scenario logics I’ve used to interpret monetary policy actions and market consequences for nearly a decade, so for me the original scenario storylines were longer-term and even more speculative. However, as we’ve moved into the crisis phase of the monetary debt trap, it has become necessary to shorten the time frame of the scenarios and concentrate on the specific stories of how the remaining years of this decades-long drama might unfold. The time frame I have selected is about two years: from ~Q1 2011 to ~Q4 2012.
Although none of these scenarios must unfold within the next two years and all of these scenarios might require many additional years, I think that any one of these scenarios could unfold within the next two years. Because of the plausibility of such dramatic changes in our immediate economic future, and the tendency toward complacency so prevalent in our culture, I decided to write the scenarios as if they are to unfold in just two years’ time. It is my hope that by seriously contemplating the economic dramas that could unfold in such a short period of time, we might engage all the more intensively in the necessary work of adaptive strategy.
To preclude a disorderly devaluation of the dollar, US monetary authorities convincingly defer a QE3 monetization of treasury debt while maintaining ZIRP and placing their faith in the nascent economic recovery. The dollar rebounds, treasury bonds drop, and long-term interest rates spike. By the end of 2011, stocks reverse 15 months of gains to test the 2010 low and housing slides to 2001 prices, as if the Great Recession never really ended. Infinitely liquid, yet secretly insolvent banks continue to prefer leveraged speculation over lending to productive enterprises. Chronic unemployment in the private sector is exacerbated by a wave of lay-offs from insolvent cities and states, pushing real unemployment above 25%. With 2012 campaigns at fever pitch and both parties vowing to slash the federal deficit and cap the debt ceiling—widely promoted as sources of the crisis—another round of fiscal stimulus and debt monetization is politically incorrect. In 2012, the dollar reaches its 2008 high, treasury bonds stage a deflationary rebound, and municipal bonds and stocks crash to their 2008-9 lows. GDP contracts and households and businesses deleverage. A generation of middle class homeowners is wiped out and median household net worth drops to $0. After enough system-wide divestment and deleveraging, banks begin expanding credit to business. Deeply disaffected citizens realizing their common plight overlook ideological differences to declare themselves Too Big To Ignore and demand real economic justice and financial reform from the new President and Congress.
To sustain the appearance of economic recovery and preclude a liquidity trap, in late 2011 US monetary authorities proceed with QE3, monetizing $1T of treasury bonds to reduce long-term interest rates. As the dollar slides to all-time lows, helped by ECB interest rate hikes, the cyclical bull in stocks extends into 2012, housing stabilizes at 2004 prices, and gold climbs to $2,025. The falling dollar and leveraged speculation extend parabolic trends in commodity prices, further straining household budgets. Following Europe’s lead, the Treasury engages in unprecedented bail-outs of insolvent state governments, preserving public employment while creating political controversy. With depreciating dollar reserves, China, India, and others continue to diversify into gold while pressuring the US for multilateral monetary reform. When the consumer-led, export-supported recovery fails to materialize by late 2012, the stock market flash-crashes its way to the 2010 low and fails to rebound. Underestimating the negative sentiment of currency markets, US monetary authorities’ promise of a QE4 is enough to precipitate a collapse in the dollar and a hyperinflationary panic into gold, silver, food, and fuel. Social order breaks down as desperate citizens steal available resources and police, national guard, and FEMA are deployed to restore order and ration supplies. While US and G20 monetary authorities conduct secret negotiations for a dollar rescue, End the Fed banking reform legislation passes both houses of Congress and awaits the new President’s signature.
To prepare for reactions to treasury bond monetization and the potential disorderly devaluation of the dollar, US monetary authorities express noncommittal openness to diversified foreign reserves and a cooperative currency arrangement. Despite their concerted efforts to talk the dollar up by promising to end all QE, the dollar slides to all-time lows before QE2 is done in June 2011 and continues to fall during QE3 in late 2011. In exchange for private US support for the renminbi as a new reserve currency, Chinese monetary authorities continue raising interest rates and allow the renminbi to rise. European monetary authorities struggle to stabilize the euro via interest rate hikes while continuing to monetize the debts of several insolvent states. In early 2012, with currency market volatility unmanageable, monetary authorities surprise the markets by announcing a new virtual global reserve currency based on the IMF’s special drawing rights—SDRs—with a fixed composition of the dollar, euro, yen, sterling, and newly added renminbi. Political rancor by G20s excluded from the SDR, such as India, Russia, Brazil, and euro-constrained Germany, overshadows the news. Derided by currency speculators as a paper bag of paper currencies, the SDR symbolizes to many critics a new cartel of would-be monetary hegemons intent on cooperative currency devaluation via mutual debt monetization. In late 2012, with the SDR price of gold soaring to new highs, the SDR fails to gain credibility as a foreign reserve asset and currency volatility ensues with a vengeance.
To preclude the collapse of the international monetary system that would be caused by the failure of monetary policy, US and other monetary authorities retain the option to redesign that system. Recognizing that market prices for gold, which has served as money for centuries, can reveal the debasement of all paper currencies, they continue working with selected banks to secretly suppress prices through high-volume naked short sales of gold futures and ETFs, while allowing those banks to accumulate physical metal at suppressed prices. As more people around the world—from central bankers to currency speculators to institutional investors to risk-averse citizens—lose confidence in the (hyper)inflationary paper currencies and trade them for gold, a tipping point is reached in late 2012 beyond which the demand for physical gold can no longer be suppressed in the derivative gold markets. As gold assumes its historic role as real money, its market price in each paper currency rises toward a level roughly corresponding with the global supply of all paper currencies, rendered via exchange rates into each currency, divided by the global supply of gold. G20 monetary authorities ratify a new design for the international monetary system. Gold is established as the one world currency, replacing discredited national currencies at current market prices. Full-reserve banking is mandated, rendering currency debasement illegal and central banks unnecessary. All debts are extinguished as central banks monetize them in their final act of debasement. The world exits the debt trap.
Which scenario is most likely? That’s a common question that tends to distract from the larger point about scenarios. Rather than single-frame, middle-of-the-road predictions to be evaluated by whether or not events happen as described, scenarios work as a whole set to provide an interpretive framework for strategic decision making. They are designed to stimulate more flexible and creative thinking about options we might otherwise overlook, such as hedges to mitigate the risk of low probability, but highly undesirable outcomes or modest commitments that appear all the more valuable because they fit multiple scenarios. Besides, in this case, there are good reasons to take all the scenarios seriously, given that we’re dealing with desperate monetary authorities trying to manage an unstable monetary system that is funding unconscionable volumes of leveraged speculation in all the major markets beyond their control.
Having observed for many years their highly refined open market operations and deliberately ambiguous open mouth operations—the strategic interplay between what they say and what they do—the best I can say is that US monetary authorities would like to steer a middle course between all four scenarios that avoids the extremes of each, just like the mythological sea-farer steering a course between the rock and the whirlpool. They would like to facilitate enough private sector deleveraging to reboot the US monetary system for yet another credit expansion via productive enterprise, while facilitating enough public sector deficit spending in the interim to ensure overall growth in output that keeps pace with the growing debt service obligations of the US monetary system. Furthermore, I think they want to be unilateral enough to excel at competitive currency devaluation, which is a consequence of government debt monetization and a prerequisite for an export-oriented private sector recovery, while being multilateral enough to preserve their long-term options for cooperative currency devaluation and, when it suits them or when they’ve run out of other options, a new global hard currency.
Why? Somewhat prosaically, I see it as the job given to them by the design of the monetary system they are charged with maintaining. Their failure to find a sustainable balance between these four alternatives will generate results that are, for one reason or another, unacceptable to them and their employers. Somewhat cynically, I suspect it is in part because this middle route between the various rocks and whirlpools has been the most profitable scenario for the financial elites near the center of this monetary system. Notwithstanding the Volcker Rule, the Consumer Financial Protection Bureau, and other politically feasible reforms of modest value, I don’t expect this dysfunction to change unless the Upgrade scenario is completed. The attempt to regulate systemic speculation, deception, and corruption without redesigning the monetary system that funds this highly profitable activity is an exercise in frustration, at best, and propaganda, at worst. However, the prospect of such an Upgrade is probably as distasteful to the financial elites running and gaming this system as a deflationary or hyperinflationary depression is to the rest of us.9
While US monetary authorities search for the elusive route between these policy dilemmas, I would not be surprised to see increasingly volatile market consequences manifesting in each of the four scenarios simultaneously and sequentially, from Reboot to Crash to Patch to Upgrade. After all, the Reboot scenario is what would happen if the debt deflation were allowed to run its course without monetary intervention. That’s what started in 2007-8 and was temporarily thwarted in 2008-9 with a series of desperate interventions. The actions they took to limit and manage the ongoing Reboot have produced consequences consistent with the beginning of the Crash scenario, which if allowed to progress too far will certainly escape their control and end in misery. To preclude this, they may have to concede to the Patch scenario, which has its drawbacks for a proud monetary hegemon-in-decline, but is preferable to a currency collapse. Finally, if the Patch scenario unfolds more-or-less as expected, then some form of Upgrade may become inevitable as more and more people exchange more and more paper currency for that most trustworthy hard currency. This whole simultaneous sequence could conceivably happen within a couple years, but is all the more plausible if we extend the time frame by as many years as might be necessary for reason to prevail.
The Upgrade scenario could take us beyond the complexity of today’s dysfunctional international monetary system to the simplicity of real money recognized around the world as true, just, and free. If it ever happens, it should eliminate the unilateral and the soft money policy options from legal consideration by future monetary authorities, which is to say that the illegal consideration will always be there. That, unfortunately, is what we might term a future certainty based on centuries of monetary history. Nevertheless, with the resolution of these policy dilemmas in favor of a global hard currency and full-reserve banking, the far less appealing scenarios framed by these dilemmas would become far less plausible.
What could we do to engage these uncertainties? What should we do? What will we do? These are the three essential questions everyone must address as one contemplates the prospects for impersonal truth, interpersonal justice, and intrapersonal freedom, for these are the three personal perspectives that structure all our actions in our worlds. As you contemplate the scenarios I have crafted along with the thesis I have presented, you will naturally find yourself evaluating my ideas in terms of your own ideas about what has been and what will be true, just, and free. As you work with the alternative possibilities, shifting your roles between reader of my scenarios and author of your own, you may notice the would-be actor behind both roles, attempting to clarify what you can, should, and will do to engage these uncertainties. You might also find yourself reflecting on what you could have, should have, and would have done in years past to better prepare for what might happen.
As you watch yourself acting out these alternative strategies, you may come to rest in the awareness that you are, within which alternative pasts and futures are but projections of the action that you do, real only to the extent that they invest spontaneous action with reflective purpose. The actual story of economic truth, justice, and freedom that eventually unfolds in moment-to-moment awareness-in-action will likely present some very real challenges to each and every one of us. I wish us all the best.
1 Business Cycle Dating Committee, National Bureau of Economic Research. http://www.nber.org/cycles/sept2010.html. Retrieved March 31, 2011.
2 Daniel O'Connor. (2006). “Debt trap.” Catallaxis. http://www.catallaxis.com/2006/01/debt.html. Retrieved March 31, 2011. The Debt Trap thesis is my own elaboration of the implications of how money is created through credit expansion by the banking system, which I learned from two outstanding sources: Ludwig von Mises. (1998). Human action: A treatise on economics. Auburn: Mises Institute; and Federal Reserve Bank of Chicago. (1992). Modern money mechanics. http://upload.wikimedia.org/wikipedia/commons/4/4a/ Modern_Money_Mechanics.pdf. Retrieved March 31, 2011.
3 Federal Reserve Board. (2011) Flow of Funds Accounts of the United States Z.1. March 10, 2011. http://www.federalreserve.gov /releases/z1. Retrieved March 31, 2011.
4 Bureau of Economic Analysis, US Department of Commerce. National Economic Accounts. http://www.bea.gov/national/ index.htm#gdp. Retrieved March 31, 2011.
5 I refer to the acclaimed documentary, Inside Job, directed by Charles Ferguson.
6 Federal Reserve. (n.d.). The Federal Reserve’s response to the crisis. http://www.federalreserve.gov/monetarypolicy/ bst_crisisresponse.htm. Retrieved March 31, 2011. US Department of Treasury. (n.d.). Financial stability. http://www.treasury.gov/initiatives/financial-stability/Pages/default.aspx. Retrieved March 31, 2011.
7 Frank H. Knight. (2002). Risk, uncertainty and profit. Washington, DC: Beard Books, p. 313.
8 My approach to scenario thinking is an application of Integral Praxiology, which is a post-Wilberian formulation of integralism centered on human action in real-world contexts. See, for example, Daniel O’Connor. (In press). “Integral praxiology: An abridged inquiry into the essential nature of human action.” In Sean Esbjörn-Hargens (Ed.), Enacting an integral future: New horizons for integral theory. Albany: SUNY Press. My approach is also informed by the scenario method originating at Royal Dutch/Shell, which I first learned from Paul Schoemaker when he was a professor at The University of Chicago.
9 Just to clarify, I hold Paul Volcker and Elizabeth Warren in high esteem and don’t imagine them participating in propaganda.