THE YEAR IS 2050: WE RECOVERED FROM AN ECONOMIC COLLAPSE AND THE WORLD IS NOW BETTER — PART 1
HOW WE CREATED AN ECONOMIC MESS
By Mirai Nakamoto
The year is 2050. I am now in my 70’s and I am having a conversation with my teenage grandchild.
- Grandpa, we currently live in a world that is incredibly prosperous. Poverty has been virtually eradicated and everybody can access global currencies and instantly transfer money directly to any individual or corporation in the world with zero fees. Yet, it seems that our generation takes all this for granted. I remember you once mentioned that, a few decades ago, governments used to control our money. Could you tell me how we got to the point we are today?
- Yes, indeed. The financial world improved dramatically in the last few decades. Let me tell you about the history of money.
Money is essentially a technology that allows us to communicate value. It is as old as mankind itself. In ancient times, humans negotiated directly with others. For instance: “I will give you 10 tomatoes for one chicken”. Then, in order to facilitate trade, we began attributing value to objects like shells, rocks and metals. We then created coins out of metals like gold, silver and copper.
Metals were not backed by anything per se. They had value only because people gave them value. They were somewhat scarce, durable, easy to recognize, difficult to counterfeit, relatively easy to transport, divide and measure. So they had properties that made them good money at the time.
Then, we got sophisticated and created banks that would store and manage our money. Banks were traditionally very close to governments. Just like religion was intertwined with the state, money was also an inherit part of the state. The government would issue, control and tax the money in its territory. The state used money as a system of control.
At some point, carrying all these heavy metals in our pockets proved cumbersome, hence banks invented paper money. For instance, a bank would issue a piece of paper that would guarantee that it could be redeemed for a certain amount of gold at the bank. For instance, “This piece of paper represents one ounce of gold at the Bank of England”.
An often forgotten fact is that the transition from metals to paper money was turbulent. In fact, it took decades, if not centuries. People were initially extremely skeptical of switching from hard metals to just a piece of paper issued by a bank. You see, trust is essentially what gives money value. Any change in money is also a change in trust. Hence, it took time for people to develop trust in the new system. But they eventually did and money evolved again.
Some centuries later, banks, with help from their sticky friend — the government -learned that they could create new money out of nothing. Let me explain.
If Alice deposited 100 ounces of gold at the bank, the bank would then hold onto 10 ounces of gold at their vault, and would lend 90 ounces to Bob. Bob would receive this money and buy something from Charlie. Charlie would deposit the 90 ounces in the bank again. The bank would then hold onto 9 ounces, and would lend 81 ounces to David. David would pay it to Ed. Ed would deposit the 81 ounces in the bank. The bank would hold onto 8 ounces and would lend 73 to the next person. And the cycle would continue indefinitely. As long as the bank holds 10% of every deposit as a reserve, it could lend the rest. You can see that the original money was ONLY 100 ounces from Alice. But the banking system was able to transform them into 1,000 ounces. After all, it was better for the bank’s profits, right?
This was known as fractional reserve banking, and most people NEVER understood it. In case you are interested in the math, you just divide the original amount from Alice (100 ounces) by the bank reserve requirement (usually around 10% in most countries). Then you get the total amount of money generated (1,000 ounces in the example above).
- Hold on, grandpa. This sounds absolutely crazy. Let me understand. The bank would hold in its vaults only 100 ounces. But somehow, now it would have created a liability of 1,000 ounces to different depositors; like Alice, Charlie and others in your example. What if Alice demanded her 100 ounces, and Charlie demanded his 90 ounces at the same time? The bank needs 190 ounces but it only has 100 in its vaults. How would the bank honor the depositors?
- You are right, my dear. In your example, the bank would need to have its debtors — like Bob and David in the example — pay their balances first. It is the only way it could honor Alice and Charlie’s claims for their money.
- But what if the debtors (Bob + David) could not pay?
- Then, the bank cannot pay their creditors (Alice and Charlie). The bank would be insolvent; i.e. incapable of meeting its obligations.
- Grandpa, that seems very risky for savers like Alice and Charlie. I would not trust my money with these banks.
- Yes, my dear. It was indeed a very fragile equilibrium that could easily implode the entire financial system if only a few creditors demanded their money at the same time. This was known as “systemic risk”. But, banks and governments got away with this for centuries because over 99% of the population was not aware of how the system worked. In fact, Henry Ford had a famous quote in early 1900’s that says “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
- I am in shock, grandpa. I feel bad for the savers. It looks like their money was not “safe” at the hands of the banks.
- You are right, sweetie. Their money was not safe at all. That was demonstrated in many historical events. You probably heard about “bank runs”, when people lose trust in the financial system and everybody wants to get their money out, but cannot since banks are just not solvent. That is why banks and government used their power to make people keep their money at the banks. If enough money was kept inside the banking system, the system would be safe from collapse.
So, to recap, for every 100 ounces deposited in a bank, the bank would hold only ten ounces (10% was a common reserve requirement). In other words, banks could leverage their deposits ten times.
Also, back in the day, people thought that they owned their money deposited in the bank. This could not be farther from the truth. When people deposited money in the bank, the money now belonged to the bank which had an obligation to the depositor. If the bank failed, depositors would receive nothing (or get in line to receive just a small fraction of their deposits). In accounting, this was known as the bank having a “liability” to the depositors, and the depositors having an “asset” at the bank. In fact, this was exactly how it was reported in banks’ financial balance sheet.
- Grandpa, it looks like people were incredibly naïve or poorly educated in money!
- Yes, I agree. Let’s continue.
With the invention of paper money, we had the creation of the British Pound, the US Dollar, the Japanese Yen and many other national currencies. You see, a currency was essentially part of a nation. It was intrinsically related to a government.
The next step was to remove the link between “paper money” and gold. That was how “fiat” currencies were created. For instance, in 1971, USA President, Richard Nixon unilaterally cancelled the direct international convertibility of the United States dollar to gold. At the time, USD 35 could be converted to one ounce of gold. Nixon removed that convertibility. The US Dollar became a “fiat currency”, and just like most currencies, it would now be backed solely by the “full faith and credit and the government”.
- Ok, grandpa. So the economy already had leverage in the magnitude of ten in the form of fractional reserve banking. Now, with no connection between currency and gold, the government would now have full control of the money supply. In other words, governments could manipulate money supply at their will, solely according to their convenience. How was that a good idea?
- Well kid, you are right. In retrospect, it was not a good idea at all. I believe this system went on for so many centuries mostly because over 99% of the people were uneducated on how money and governments worked. Even highly intelligent people like doctors, lawyers, engineers, etc. would often have no clue about how the monetary system worked. People were just too busy making a living. And, studying the monetary system, although very important, was not very sexy. When I was young, I never approached a girl saying “let me talk to you about our monetary system…”
- I understand, grandpa. But I am curious: If governments had full control of the money, including being able to print new money out of thin air at their convenience, how did we keep governments honest?
- People could not keep governments honest. For example, let’s examine the financial situation of the USA around 2018.
USA Gross Domestic Product was around USD 18 trillion per year. Government revenues were around $3.2 trillion per year. Government spending was around $3.7 trillion per year. Hence, the deficit (revenues minus expenses) was around $0.5 trillion per year.
To make things worse, the government outstanding debt was already at $20 trillion dollars in total. Assuming a low average interest rate of 2% per year on this debt, the government would also have to pay another $0.4 trillion per year in interest to its creditors. Hence, now the annual deficit was almost $1 trillion (= $0.5 trillion from the fiscal deficit plus $0.4 trillion from interest payments).
This $1 trillion deficit had to be financed. So the total government debt would now increase to $21 trillion. In just one year. In fact, the situation was so dire that total USA government debt went from $6 trillion in 2002 to $20 trillion in 2017; an increase of over three times in just 15 years.
Now the above picture reflects the USA. But remember that virtually every single country had a similar picture. Japan, Europe, China, Brazil… This was not a USA phenomenon; it was global. In fact, global public debt went from $26 trillion in 2005 to over $60 trillion in 2018. That had never happened in history. This was a financial experiment being carried over by governments.
- Stop! What if interest rates on this massive outstanding debt went up? This would increase annual interest payments overnight. This would threaten the financial stability of the government, right?
- Yes, kid. The government was able to keep adding to its debt year after year only because creditors were still accepting its debt. But as you can imagine, at some point the dance could stop. Creditors would just stop believing in the capacity of the government to repay or roll the debt. So governments would default.
Now, remember that a government can fund itself in three ways:
(1)Taxation; which most people understand.
(2) Issuing debt; which most people also understand.
(3) Printing money of out of thin air, which would also increase the debt. This was often misunderstood. Since fiat currencies were backed solely by the faith people have in the system, if governments ran out of money, they could just print new money at their convenience. They did this through central banks. In the USA, this was Federal Reserve, known as the Fed.
- But grandpa, it seems like governments could go a spending spree like there is no tomorrow. What incentives did governments have to be financially responsible?
-Governments had exactly ZERO incentives to be financially responsible.
- This sounds crazy, grandpa. It is the equivalent of giving the only gun in town to the psychopath.
- I agree, kid. Why don’t you make an analogy to a family budget to make sure you understand?
- Sure. Let’s imagine a family making $50,000 per year. Their expenses are $55,000 per year. So they have a deficit of $5,000 per year. They also already carry a total outstanding debt of $60,000 with interest rates of 2%. That means they have to pay $1,200 in interest per year just to service their debt. So, their debt would increase from $60,000 to $66,200 next year. The increase in debt would go on year after year, until it reaches a point where creditors decide to no longer finance the family. The family is now broke.
However, this is not a normal family. They are a super-powerful family that has a “magic button” where they can print new money out of thin air and just keep increasing their debt, like there is no tomorrow. That would go on, until the point where creditors stop accepting this newly created “fake” money. Now the family is finally broken for good. They cannot afford their next meal.
- I like your analogy, kid. Here is also another way to think about it. The GDP of the USA was growing about 2 or 3% per year, which means an increase of around $0.5 trillion per year in GDP. The debt, however, was growing at over $1 trillion per year. So, debt increased by $1 trillion and growth was only half of that.
- Grandpa, this is like the family income increasing by $5,000 but the debt increasing by $10,000. How great is that?
- Exactly, kid. We kept seeing statistics saying the economy was improving, however nobody mentioned that the debt was growing about twice as fast as the economy. In fact, all kinds of debt were achieving record levels: student debt, credit card, auto loans, mortgages, corporate debt, government debt, etc. Public pensions were also a time ticking bomb in virtually every country as the young population was quickly becoming unable to pay for the promised pensions to the older generations. We were living in a debt-based economy!
- So, grandpa, money backed by “the full faith and credit of the government” did not really mean anything. This sentence sounds strong and powerful, but the reality was that the system was very fragile. Which faith and credit exactly? The government was already broken from a financial perspective! No one in their right minds would allow this to go on.
Also, fractional reserve banking already does not sound very smart. And allowing government to fully control our money sounds communist. How could you consider yourselves a capitalist society? If money was fully manipulated by the government, this was not capitalism at all!
- I am forced to agree, kid.
- Grandpa, unfortunately, it sounds like people in your age were just too passive to accept all this. Your generation should have been more curious, asked more questions! Please tell me how this all evolved to the point we are now!
(this is the end of the first part of the article. For the second part, click here)