The utility of a fiat monetary system

Let’s try a different approach.

In order to be able to do this:

Graph: Federal Government Debt: Total Public Debt

Government has only two options:

Option 1 – GDP must advance faster than debt (this, incidentally, is the ideal option)

FRED Graph

Since 1980, Federal debt has expanded from roughly $1 Trillion to just shy of $12 Trillion. That is an advance of well in excess of 1000%. But as attested by the above official data, GDP has only expanded from $6 Trillion to just above $13 Trillion. That is an advance of just over 100%.

Thus option 1 is clearly not in play here.

Option 2 – Interest rates must be manipulated lower

FRED Graph
Yup! There it is.
Therefore, just like in a family household, if you want the ability to spend progressively more than the year before, either your salary must increase or you hope for interest rates to drop.
Having retained the exclusive and arbitrary right to manipulate interest rates, government does so with gay abandon… in its own favor.
The trouble with manipulating interest rates lower artificially is that you create dislocations in a number of sectors like pension payments and savings.
One of the ramifications of lowering interest rates is that you encourage corporations to take out loans. This is perceived as a good thing as borrowing and spending on the part of corporations results in increased demand thus increased production hence increased employment.
This is a good thing for as long as the borrowed money is put towards building intrinsic value which is usually the case at the outset of the inflationary dynamic.
However, as interest rates are kept low and manipulated lower still and as government and the corporate sector spend progressively more, the central bank has to keep up with the creation of physical currency. This is what inflation is all about.
Increasing rates of inflation discourage the public from saving. Essentially, inflation erodes the purchasing power of the currency thus as consumer try to find more profitable ways to deploy their savings, they too end up goosing demand. Once again, this is perceived as a good thing by government as more spending will create even more demand, thus more production thus more employment.
As government keeps the pedal to the metal and pushes greater degrees of inflation into the system, the public eventually runs out of savings. This is the point at which any spending in excess of revenue must be met with debt.
At this point you have government, the corporations and society all feeding the debt dynamic.

Graph: Household Sector: Liabilites: Household Credit Market Debt Outstanding

Since 1980 household debt progressed from about $1 Trillion to just shy of $14 Trillion… that is a rise of well over 1000%… yet again.
To recap. Today we have Federal and Household debt combined that advanced from about $2Trillion in 1980 to about $26 Trillion today…. whilst GDP went from about $6 Trillion to about $14 Trillion…
You do the math….
So, what is the utility of a fiat monetary system.
Clearly, a fiat monetary system enables government to spend liberally and, seemingly, endlessly. Unlimited spending power means unlimited political and military power thus unlimited power over people and countries.
But even in a fiat monetary system, inflation is not infinite thus spending cannot be either.
Inflation is a dynamic that is necessarily exponential and finite.

Graph: M1 Money Multiplier

There it is. That’s the multiplier. What this graph shows is the diminishing effect each additional Dollar has on the overall expansion of GDP. Ergo, it shows the exponentiality of inflation whereby you always need more credit and money creation to bring about the same % of GDP expansion. Essentially, for as long as the multiplier is above 1, each unit of currency has a multiplier effect on the overall economy. That is because each coin or each Dollar bill can be used several times in different transactions.
But when the multiplier is below 1, additional currency has no effect on GDP expansion.
We can argue as to what the reasons may be for the declining effect of inflation. My preferred theory is that at the beginning of the inflationary cycle there is a legitimate need for seed money to create industry thus employment thus demand. But as you force credit down the throats of corporations and individuals, there is only so much useful and intrinsically valuable investment that can be carried out before all this excess money spills into frivolous endeavors. The fact that industrial capacity utilization though sinusoidal slopes from the upper left to the lower right and is now at around 70% is fairly strong evidence of redundant and unnecessary investment in industry and commerce.

Graph: Capacity Utilization: Total Industry

In a democratic environment, subsequent administrations are loath to have less money to spend than previous administrations so that inflation becomes a perceived necessity. Furthermore, as GDP is the measure against which the success of an administration is measured, if a little inflation gooses the GDP number, then politicians feel that lots of inflation will rightly goose it even more thus bringing them great praise.
Thus, a fiat monetary system in a democracy not only guarantees excess debt and, eventually, the bankruptcy of government but it also ensures that by the end of the inflationary cycle, government is the largest actor in the economy.

(link fixed in Septeber 2010)

As the largest actor in the economy, the survival of government becomes intertwined with continued inflation. Thus, towards the natural end of the inflationary cycle, government has a vested interest in disregarding the law in an effort to maintain a positive inflationary trajectory.
Thus, the genius of a fiat monetary system that could be employed to fine tune the economy and mitigate the effects of the natural ebb and flow of economic activity is wasted by politicians that act in the only way that a democratic political system ensures they should act; that is, they must be short term greedy opportunists and it helps if they are ignorant to boot.
So the presumed holy grail of politics which is, at least ostensibly, to reach a perpetual high plateau of prosperity and well being is virtually guaranteed never to happen in an unchecked fiat monetary system.
The theoretical solution to our predicament would be the establishment of an enlightened autocracy. However, the historical record shows that this solution too has never brought lasting well being upon any society. Democracy truly is the worst political system except all the others that have been tried. The only saving grace of democracy and a fiat monetary system is that along the way society does truly benefit from advances in technology, science and the arts.
My beef is that it is an integral part of fiduciary duty to look at where we came from and where we are with a constructively critical eye.
Once again however, the historical record shows that the self proclaimed holders of the moral high ground won’t do that and, as they feel power slipping through their fingers to an agitated populace, they will plunge us into a world war.

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15 Responses to “The utility of a fiat monetary system”

  1. The inevitability of the diminishing marginal utility of debt… part II « Guido's temple of the absurd Says:

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  2. Pat Donnelly Says:

    Steve Keen has quantified this idea also. You may find him interesting if you like econ math!

    Steve is still wrong, but not as wrong as Mish, about Oz housing. Yet!

    • guidoamm Says:

      Hello Pat,

      You’re on quite a roll here! Glad you found time to read through some posts.

      I’ve come across Steve Keen when he wrote the Roving Cavaliers of Credit and it was immediately the right fit for this blog. There is a link to his blog from mine.

      Steve and Mish may not be right yet as you point out but the simple fact that the Australian Dollar is linked to the US$ is enough to ensure that, eventually, Australia too will pay. And as you pointed out, money is a claim on assets (presumably tangible assets). So at some point when enough credit derivatives will require rolling over and or settling, all Western countries will have to pony-up … but … the intrinsic asset base will not suffice to satisfy the claims… this of course is a process rather than an event and we’re already witnessing this dynamic in motion with the various emergency funds and swap lines…

      Anyway. I doubt we’ll actually see the final denouement of the monetary system because, before that happens, our leaders will very likely precipitate a crisis of global import. In my opinion, this crisis will take the form of a war.

      Time will tell.

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  12. guidoamm Says:

    Good finds DL, thanks.

    Shades of Smoot-Hawley all over again. Once again. This is only too predictable in a democratic environment.

    We’ve seen this movie before. We know how it ends.

  13. David W. Lincoln Says:

    I think this ties in. Guido, why is it that Canadian news sites are the only one’s who report this, and this, and this, ?

    An unwillingness to concede that some policies are wrong, because the need
    to justify those policies is so great that it is better to go down with the ship,
    rather than concede policies are wrong: this is my explanation. Yours’ is?

  14. David W. Lincoln Says:

    These are steps in the right direction, Guido. I maintain the people, with more on the ball & who pay attention to Michael Walker, amongst others, are more likely than John & Jane Q. Public to effect initial change.

    Any revolution starts from above, and it makes its way down to the average person.

    What is needed is for the people with more on the ball to band together and declare a Government in exile, so that they take the reins away from the duller knives in positions of authority.

    After all, to paraphrase Daniel Hannan, Barack Hussein Obama is the devalued President of a devalued government, and the same can be said
    of the rest of those who are heads of government. For each of them is a
    devalued head of government, of a devalued government.

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