How the paper money experiment will end

A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this senario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.

This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.

We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.

So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?

There are at least seven possibilities:

1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.

2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.

3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.

4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.

5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.

6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.

7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.

Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.

This article was previously published at

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8 replies on “How the paper money experiment will end”
  1. says: Paul Marks

    One thing governments could try is to tax payments on government debt – and to tax it at source (so that the tax hit people and enterprises based overseas as well as domestic debt holders).

    They could say “this is NOT a default – it is simply treating money invested in government debt on the same tax basis as money invested in productive industry”.

    It would not change the fate of the present system (it would still collapse), but it might put off the collapse for a little while.

    The American government could also end the deductible of State and local tax from income before it subjected to the Federal income tax.

    These two moves (taxing all income from government debt – and ending the deductibility of State and local taxes) would bring in the rich people of New York and California (many of whom presently manage to avoid a lot of the Federal tax net) very much into the system.

    I repeat – this would NOT save the system, but it is a tactic that could be tried for a while.

  2. The only honorable option is to drastically reduce government spending, liberalize the economy through regulatory reform, and stop money printing (preferably by tying the money supply to gold). The welfare/warfare state is destroying centuries of progress to free the individual from the predations of the state. The US could accomplish this by simply abiding by the provisions of the Constitution. What a novel thought!

  3. says: Paul Marks

    Yes Mr Barron

    The “common defence and general welfare” is the PURPOSE of the specific spending powers then listed in the Article One, Section Eight of the Constitution of the United States.

    To pretend (as corrupt courts have) that there is a catch-all “general welfare spending power” is a lie – indeed a vicious lie.

    However, with a Supreme Court appointed by the government itself what chance is there of the limits on the Federal government being enforced?

    Surely hope died in 1935 – when the Court ruled (by five votes to four) that even tearing up the gold clauses in private contracts and stealing privately owned gold from the people (something that even George III did not try to do) was constitutional.

    If that is constitutional then (as the dissent famously said) “the Constitution is dead”.

  4. says: joe bongiovanni

    “”A paper currency system contains the seeds of its own destruction……. A paper money system leads to excessive debt.””

    Your so-called paper money system is a private-banker-issued-by-debt-instrument money system.

    Since all bank-credit money is created in the nominal amount of the loan deposited into the borrower’s checking account (M-1), but the debt that is established via PN includes the bank’s profits (so-called interest payments), there MUST BE more debt than money from each transaction, thus your statement that the debt must be ‘excessive’ when compared with the ‘money’ available for debt-service payment, is axiomatically correct.
    The solution to the excess debt paradigm extent with bank credit money is public issuance of money without associated debt; i.e. public issuance of equity-based monies.
    For the Money System Common.

  5. says: chuck martel

    Attempting to prop up a failing, decaying fiat money system by any method is a mistake. Let the state and its cronies do as they wish but try to insulate oneself as much as possible from the negative effects of their machinations. The sooner the system blows up, the better. The next generation will hopefully arrive at a solution that doesn’t involve fiat money.

  6. says: Tony Baverstock

    The problem with this paper is again it looks for errors in the system not the governments who borrow.

    For example:

    “A paper currency system contains the seeds of its own destruction.”

    I assume the paper means its destruction by excessive debt. However, debt is not limited to a paper money system. Even if all money moved to a solution a government would still be able to borrow beyonds its means so long as a holder of bit coin would lend. Even in a barter system a government could run up debt by borrowing a real item, say food, and promising to pay back later.

    “The temptation for the monopolist money producer to increase the money supply is almost irresistible.”

    I agree with the sentiment but again the comment is simplistic. If an economy is growing money supply should grow at the same rate. The problem is not with the money system but the control the governments maintain over the means of controlling the money supply,i,e interst rates. We can all agree over time governments have attempted to maintain short term interest rates at artificially low levels. This encourages debt build up since if the value of an asset grows more than the interest rate it better to borrow and buy than wait. However, while this encourages excess personal debt it does not create excess government debt. Government do not borrow to invest and make a gain they borrow to spend.

    “In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later.”

    Again this is simply incorrect. The statement is only true it the costs of money is less than the costs increasing prices.

    None of this says why the current money system is broken. Indeed, the system is just a system. I cannot think of a better one for now but what has been proved is if there is a way of playing the system, governments will do it.

    The real point is what is going to happen now. The paper lists a number of options although it ignores only least painful one, which is to grow your way out of the problem. Most governments are attempting this, although the Japanese version is also inflation. I think we all know this will not happen in every country and some of the other options may have to be used.

    What is important is that if we get out of the mess we need to stop governments getting us back in.

    1. says: Robert Sadler

      If only governments used the “system” correctly all our problems would be solved? This seems like a hopelessly naive sentiment.

      What is important is that if we get out of the mess we need to stop governments getting us back in.

      Who is “we”? Artful use of this word is a common way of removing responsibility for solving a poorly defined problem from yourself and projecting it on to others. A common approach of politicians.

  7. says: Paul Marks

    Tony Baverstock it is quite true that a government (the Bank of England has been 100% government owned since 1946, and the American Federal Reserve would not be able to expand them monetary base without government backing) paper money system could, theoretically, avoid monetary expansion (the old meaning of the word “inflation”).

    So, in theory, a paper money system could avoid inflation (note to the uninformed – the word “inflation” does not just cover “prices in the shops”, monetary expansion is inflation whether or not price in the shops go up or not – indeed, for example, the terrible inflations of the late 1920s, by Benjamin Strong, and in recent years, by Alan Greenspan, did NOT involve massive changes in “prices in the shops”).

    Inflation could be avoided by simply not printing any more money (as long as the banking credit bubbles were allowed to collapse taking money back towards the monetary base – as they were allowed to collapse, taking the banks to rightful bankruptcy, in the 19th century)- but what would be the point of such a system? Why exchange a commodity money system for a system of paper money if the paper money is not increased?

    Remember the purpose of a paper money system – the reason government pushed people (via legal tender laws and tax demands) to move from commodity money to fiat (whim – command) money.

    The purpose of the fiat money system for it to be easy to increase the quantity of money – that is why governments pushed it in the first place.

    And even governments did NOT run a fiscal deficit – they would still want a “cheap money” “low interest rate” policy, in order to create an artificial “boom” (the point of increasing the money supply in the first place).

    If lending is just from REAL SAVINGS – then there is no point in having a fiat money system.

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