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Our exponential debt system

Gold coins The word “debt crisis“ has made it into everyone’s vocabulary by now. People are talking about how we were “living beyond our means” and are debating how spending cuts, tax raises or some combination of the two could be used to salvage the situation. However, often times there is a gross misunderstanding about why there is so much debt in the first place and why it seems to constantly grow. Many people fail to see that growth within our current monetary system relies on exponential increases in debt.

To understand the debt crisis, you have to understand that in reality this is a “money crisis”. Let me explain this further.

Today, all money is created in the banking system. It originates from the central bank and is brought into existence by an extension of its balance sheet. This means that there it is a simple booking entry: new money on the liabilities side, and debt on the assets side. Yes that’s right: money is created through credit – which is nothing but a nice word for debt. In contrast to most of human history – where money has been a tangible asset with intrinsic value attached to it, such as gold and silver – today all dollars, euros, pounds and all other currencies are based on debt. This is taken on by governments, companies and private citizens all over the globe. Implicit in this is trust on the part of lenders that this debt will be repaid one day in the future.

So what's the problem? Let’s say you take out a loan for $100. The money you receive will be created from nothing once you sign the paper to take out the loan and you are then obligated to pay back $105 after say one year. Now here is the all-deciding question: Where is the interest coming from that you need to pay back the loan? At the moment the only money in circulation is your $100. The only way to solve this riddle is that somebody somewhere in the economy has to take out another loan to create the money that enables you to pay back the first loan.

This in essence is how our so-called “modern” monetary system works. It can only work if there are always people who are willing to take on new debt. This is because if people start paying down debt instead of borrowing more, then bank lending collapses – leading to drops in broad money supply measures such as the Federal Reserve’s M2 measure. (The Fed used to publish an even broader money supply measure, M3, but stopped reporting this number back in 2006). This will make it even harder for the remaining debtors to find the money they need to pay back their debts, because to recap: the interest is always missing and there is always more debt than money. This is what many call the “deflationary death spiral” in which more and more money (credit/debt) disappears leading to the insolvency of remaining debtors (which equals wealth destruction on the side of the creditors). This leads to a standstill in economic activity (companies fail, because falling prices halt consumption) and therefore skyrocketing unemployment. This is every politician and central bankers’ worst nightmare.

This is the reason why in our current system it is deemed politically impossible to reduce overall debt. There can be deflationary shocks – as seen in 2008 – but central banks will fight such deflation tooth-and-nail in order to prevent the aforementioned deflationary death spiral. In practice, this means buying lots of bonds (public and private) off of banks – purchases that are funded by newly created electronic money. In order to maintain debt-based growth and avoid short-term economic collapse, government debt must expand in order to compensate for the collapse in private debt growth. This also applies in reverse: the government can reduce its debt, but only if the private sector increases its debt, so that total debt and therefore the money supply doesn’t shrink.

So why can this debt based system only work for short periods of time? Think about what happens if we do not pay down debt. Due to compounding interest the amount of debt will keep rising automatically – and exponential. The current financial structure can therefore only be stable if economic activity increases along with the debt so that the debt is still backed by something (the labour of the debtor) and doesn’t turn “toxic”. This experiment has been going on for over 40 years now, ever since Nixon "closed the gold window" in 1971. We’ve come to the point at which economic growth can no longer hold pace with the unmerciful debt machine. Therefore the relative debt levels (debt to GDP) are constantly rising – a clear signal that should have anyone worried.

During the last deflationary shock in 2008 the world’s major governments stepped in to prevent the system from collapsing by rescuing many bankrupt institutions. By doing so they have become insolvent themselves – as is becoming more and more apparent in Europe. But all developed economies are to one extent or another facing the same problem. The fiat money system is in dire need of somebody still able and willing to take on debt to keep everything running. But we’ve reached a point of debt saturation. And even if we were to find new debtors this would only buy us a bit more time – and a greater altitude – before the inevitable fall.

By mathematical certainty the debt money system must and will collapse. Either through the described deflationary collapse or through ever-larger "rescue packages” (a euphemism for money printing) whereby the public is forced to take on the toxic private debt by devaluing the currency. As people lose faith in fiat currencies, a resulting hyperinflation will produce the same result as the deflationary collapse. Promised payments from debt instruments will implicitly or explicitly be defaulted on.

To sum up: In a debt based fiat money world there will always be debt for if there was no debt there would be no money. Since debt is not paid off, the compounding interest on it forces us to grow at the same pace. Since this experiment has failed we are now facing the collapse of this debt system. Prepare yourself accordingly by diversifying into tangible assets such as gold and silver, and by educating yourself and your loved ones about the nature of the economic challanges they are likely to face in the years ahead.

Author: Chris Volke