Home > Macro/Monetary Theory > Why Hyperinflation is Not a Threat II: Debt and Anti-Debt

Why Hyperinflation is Not a Threat II: Debt and Anti-Debt

Last time I told you that money does not represent a debt from the Federal Reserve and that even if it did, it would not serve as an anchor for the real value of a dollar because the assets of the Fed are also denominated in dollars.  So what does money really represent and what does anchor the real value of a dollar?

In the past, paper money was created by banks.  You could take gold or silver or something of the sort to a bank and they would give you a bank-note which could be redeemed at any time for some quantity of gold or silver or the like in the future.   As long as people generally trusted the health of the bank, they could trade the notes instead of the gold or silver which was somewhat more convenient and also allowed for an “elastic” money supply (I’ll postpone a discussion of that topic).  Originally, the government got involved in money essentially by assuming the same job as a bank.  They would trade dollars for gold and gold for dollars at a given rate.  In this scenario, money represents a debt from the bank or the government to the holder of the note.  The gold or silver or other real good which backed the money is a sort of “anti-debt.”  It is the means by which these debts can be extinguished.

Today, money is not backed by gold or silver or anything in this manner.  The process of money creation is of an altogether different nature. There are a few different ways it is done but they amount to essentially the same thing.

If you buy a government bond, that represents a debt from the government to you.  It is redeemable at a fixed time for a fixed amount of dollars.  The dollars you use to buy the bond do not represent a debt from you to the government.  They represent the means by which the government can extinguish its debt to you.  At the appointed time, the government must produce the requisite amount of dollars to retire your bond or else default on its debt.  The number of dollars required to do this at that time does not depend on variables such as the price level, rate of inflation, real interest rates, GDP, etc..

If you sell a government bond to the Federal reserve, the debt which the government owed you is transferred to the Federal Reserve.  The dollars which the Fed prints and gives to you represent the means by which that debt can be extinguished.  The Fed doesn’t owe you anything, the government owes the dollars to the Fed.  When the bond comes due, the government must either get dollars from taxes or issuing more bonds in order to retire that bond, or, as they normally do, just issue another bond and give it to the Fed, which cuts out the middleman (you).

Alternatively, the Fed can loan to a bank.  When a bank borrows dollars from the Fed, it’s not the Fed that owes the bank, it is the bank that owes the Fed.  The dollars, again, represent the means with which the bank is able to extinguish this debt.  The principle is the same, in either case, the dollar is created and traded for debt.  In both cases, the debt is from someone else to the Fed and the dollar is not the debt but the “anti-debt.”  This is an important distinction between modern fiat money and traditional bank-notes which, at one time were backed by gold or silver.

To see how this provides an anchor for the value of a dollar, we must go a step farther.  If the Fed loans to a bank, that money becomes part of the bank’s reserves.  If you sell a government bond to the Fed, you most likely deposit the money which you get in return in the bank and it becomes part of bank reserves.  Alternatively, you may spend it on something else, but in this case the person to whom you pay the money most likely deposits it and it becomes part of bank reserves.  I can drag this out through as many steps as you please, but the point is that most of this base money will end up as bank reserves.

The money which the Fed creates and which is able to extinguish Federal Reserve debt is the money base.  Some of this ends up in people’s wallets but most of it ends up in bank vaults (or accounts with the Fed which amount to the same thing).  The base money that ends up in bank vaults acts exactly like gold did in the old system.  It is anti-debt.  The banks then issue bank credit on top of this which is debt.  This bank credit takes the form of checking accounts, saving accounts, certificates of deposits and so forth.  If you deposit a $20 bill in the bank and they add $20 to your checking account balance, this is a modern form of bank credit.  It is redeemable at any time at the bank for $20 in cash.  Again, the cash is the anti-debt into which this bank credit is convertible.

And just like people could use bank-notes to transact, we now can use this modern bank credit.  You can go to the store, buy a gallon of milk and pay with a check or a debit card.  At the end of the day, the store will deposit the check with their bank and their bank will settle any balance that arises with your bank by transferring cash, just like in previous times banks would have settled by transferring gold.  So what we typically call “money” and what we use to buy things is made up of both base money (currency) and bank credit.  The bank credit represents a debt of base money from the bank.  The base money is anti-debt opposing some debt with the Federal Reserve.

But not all bank credit is created from depositing currency.  The majority of it is created in opposition to a new debt to the bank.  This process is just like the one described above when the Fed creates base money.  Someone goes to the bank and wants a loan.  The bank may give them a loan in the form of bank credit. Alternatively, the story often goes that the bank lends cash and the borrower spends it and the then whoever they gave it to puts it in their bank and their bank lends some of it as cash and this process continues.  It makes no difference which story you tell.  The result is that bank credit increases the quantity of what we call money beyond the quantity of base money created by the Fed.

This increase in money comes with an increase in debt.  This is the key.  The debt is nominally denominated. In order to pay it off, someone must produce a fixed quantity of dollars.  If they don’t pay their debts, there are usually undesirable consequences.  Usually those consequences involve the loss of some real property.  If you don’t pay your mortgage, the bank takes your house.  If you don’t pay your car loan, they take your car.  If a business doesn’t pay their debts, they go bankrupt and the creditors take their assets.  It is all of these assets securitizing all of the debt which is created in the process of creating our money that provides a real anchor for the value of a dollar.

Maintaining a stable value for the dollar depends on maintaining a balance between the quantity of money and the quantity of debt.  The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is because people with debt need those dollars to pay off their debt.  They won’t just decide not to take them.  If some people suddenly lost confidence in the dollar and decided not to hold any, those people with debt would be happy to take them off of their hands.  In fact they would compete over those unwanted dollars.  If someone owed $10,000 on their car, and not paying would result in the loss of the car, then they would be willing to trade any possession they own which they value less than the car for $10,000, including some quantity of their labor (or the car for any amount of dollars greater than $10,000).  In this way, all of those assets–the houses, cars, boats, businesses, etc.–which secure all of our debt are “backing” the dollar.  Dollars are convertible into these assets at a fixed rate.  It’s just that this rate varies from person to person, there’s no “car standard” or “house standard” so it’s not obvious to people.

What’s more, the process by which money is created, destroys money when reversed.  In other words, when people pay off their debt, the money supply decreases.  Now here’s the kicker.  Here is M2 (base money plus most forms of bank credit).  Here is total credit market debt owed.  Notice that total debt is about five times the size of M2.  Now consider what would happen if people did the opposite–that is, if people decided that they didn’t want to hold debt any more.  They start deleveraging and the money supply starts to contract.  As this happens the price level starts to fall.  There are different ways to explain it but they amount to the same thing, people compete for the dollars that they need to pay down their debt by offering other goods and services at a more favorable rate.  As the money supply contracts, it gets harder and harder to get the dollars required to pay off debt.  The prices of goods fall but the value of debt remains the same since it is nominally denominated.  Since there is more debt than money, it is impossible for everyone to get out of debt, some people will have to default.  This can result in a mad scramble to get the limited quantity of dollars so as not to be left bankrupt and with no real assets.

This is a deflationary scenario and this is the true danger which constantly hangs over our economy.  This is exactly what started to happen in 2008.  Notice in the graph of total debt, that it begins falling short of the trend right before the recession.  This is why the government stepped in and started throwing borrowed money at the economy to stop the bleeding.  When the private sector isn’t willing to borrow enough to keep the money supply growing fast enough to keep up with (artificial) inflation expectations and hold off this contraction, the government has to do it.  I’m not saying this is desirable or natural or unavoidable.  It’s an artificial problem we have brought on ourselves but if we really want to have any chance of fixing it, we have to understand what’s really going on.  We can’t just complain about the debt and ignore the system that makes it necessary.  If conservatives every got into power and actually tried to balance the budget without completely reforming the monetary and financial system, it would cause a recession that would discredit conservatives and free-market economics for a generation (at least) and probably destroy the Republican party.

  1. September 17, 2013 at 12:20 am

    “The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is ”

    You are aware that there are many real life historical cases of hyperinflation where people stop accepting a currency, right? Long before they are printing $100 trillion bills people usually pay off their debts.


  2. Free Radical
    October 19, 2013 at 6:42 pm

    Yes but the point is that we wouldn’t be able to pay off all of our debts because when they create new money they also create new debt. In the cases in which hyperinflation occurred, the government just printed money and spent it (rather than the central bank printing it and lending it). This is what people are missing. It is true that the government can take on an increasing proportion of that debt and if they are willing to do this and the Fed is willing to let them then it’s possible that they could cause a hyperinflation but it is by no means necessary and I think the opposite is much more threatening.

    P.S. sorry for late response, this comment slipped by me.

  3. January 23, 2015 at 12:01 am

    I came to the same conclusions at the beginning of 2015 independently. Better late than never I suppose. But kudos to you for working it out before me!

    • Free Radical
      January 23, 2015 at 12:48 am

      Thanks derekrss, the more people work it out the better (assuming this is not spam, it’s sufficiently vague that it might be, but it’s unusually coherent, so I’m treating it as legitimate.)

      • January 23, 2015 at 1:22 am

        Vague but coherent. Yes, that about sums me up!

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