The central banks of the world are printing money like confetti.
While this has had a strongly inflationary effect upon financial assets, the degree to which it has caused inflation in more standard goods and services has, thus far, been more modest. This may not last and could rapidly degenerate either into 1970s style high inflation, or even skyrocketing hyperinflation. Unfortunately, the alternative of not printing money, or printing less money, would cause the entire private financial system to collapse and, unless the central bank directly held all deposits for both private individuals and businesses – which it currently does not – the resulting fiscal contagion would be economically catastrophic.
There is, however, a way out. A way to both keep the system liquid, continue to fund important welfare programs at a time when they are needed more than ever, and, at the same time, keep inflation reigned in.
Many people are vaguely nervous that our financial system might soon fail, without exactly knowing what the risk is, or how to avoid it – and the good news is it can be avoided.
This article explains the exact nature of the risks of both inflation, on the one side, and financial collapse, on the other, and how to avoid both outcomes.
Understanding Inflation
To understand why the huge increases in money supply have not yet lead to a proportional increases in the prices of many products – and also the potential danger of disastrous future hyperinflation – it is important to understand the relationship between money supply, money velocity, the price of goods and the quantity of goods transacted in the economy each year. The relationship of prices to money supply is described by this equation:
MV = PT
Where
M = money supply
V = money velocity
P = price
T = total underlying value of goods transacted
Put simply, if the amount of a given good available to be purchased remains constant, the price of each unit of the good is simply proportional to the total amount spent on that good. The money supply is the total amount of money out there, while the money velocity is the amount of times each unit of money gets spent per unit time. Money supply times money velocity equals total spending per unit time.
Where does money come from?
Under our current debt-based system, all money is initially lent into existence, either to individuals to boost consumption, to business to purchase capital and cover any other lead costs required to produce saleable products, or to the government to facilitate public spending in excess of their tax intake.
Mike Reiss has put together a very good video explaining how the balance of money creation and money destruction combines to set the overall money supply.
When these loans are paid back, then money is effectively destroyed.
Our current banking system needs a continuously increasing money supply to avoid catastrophic collapse
The root cause of this is due to the fact that 97% of all money is held in deposit accounts in private banks and, furthermore, that private banks are by far and away the most convenient way for transacting parties to make large payments to each other. So if all the private banks suddenly failed, the results would be catastrophic! Most people wouldn’t have any liquid wealth at all (as all deposits would be lost) and large businesses would have no means of paying each other and so most long supply chains would disintegrate and the production of vital goods and services (including food and utilities) would grind to a catastrophic halt.
So at the moment, we cannot afford to let private banks fail in large numbers.
And to avoid fiscal contagion and a mass failure of private banks, the money supply must continually increase.
The reason for this is because, if the amount of money a bank owes to depositors should exceed the amount of money the bank can reasonably expect its debtors to repay in loans with interest, then the bank will go bust.
And one bank going bust greatly increases the chances of more banks going bust. And indeed, if even a moderate fraction of the banks go bust, then the entire system will collapse!!!
The reason why a contraction in the money supply leads to a sudden and disastrous knock on effect in the banking system is because:
- The quantity of outstanding loans is finely balanced with the quantity of deposits
- Both the default rate and the value of the assets, which loans are secured against, both depend and affect the degree of spending in the economy…
…so less loans cause less consumer spending, which in turn cause businesses to become insolvent and lay off workers. This in turn leads to reduced wages and asset price depreciation. This produces more debt defaults in a vicious cycle which, if allowed to perpetuate, would completely collapse the banking system – and cause a corresponding catastrophic failure across the entire economy.
As a side note, the reason why private banks and financial institutions going bust would be catastrophic is due to the heavy reliance of businesses and individuals on these institutions to hold and transact liquid wealth. If the central bank provided these account deposit and money transfer services to businesses and individuals directly instead of through private banks, then a money supply contraction (and the corresponding bankruptcy of many private banks) would have far less serious ramifications for the wider economy.
If a total financial collapse resulting from the simultaneous failure of all the private banks can happen so easily, why hasn’t it happened already?
The reason why a total financial collapse has not yet occurred is because it is very easy to increase the money supply and, hence, prevent the complete collapse of our private banking system. The central bank can simply loan money to private banks, who in turn loan it out to people and businesses who, through the multiplier effect, create even more money and economic activity. Failing that, if noone’s looking for loans or has sound business plans, due general economic pessimism, the central bank can buy bonds bonds from the government who can spend that money into the general money supply through welfare, expansion of public programs and services, or government subsidies to private institutions.
So, since increasing the money supply is as simple as adding a few extra zeroes, it’s easy to ensure the money supply keeps going up, the banks remain solvent and the entire financial system doesn’t collapse.
The catch is inflation. If you increase the money supply and the money velocity starts to increase, then this causes the prices of goods and services – and the corresponding cost of living – to go up. As long as this is gradual, it’s not a big problem. But, if the rate of inflation starts to worry the general public, it can rapidly lead to a vicious cycle. People spend their money as quickly as possible for fear that the longer they hold onto it, the less it will be worth. This increases the money velocity still further, which causes the rate of inflation to increase even faster. As the cost of living increases, people who can’t pay their rent, or purchase food, start panicking and demand higher wages from their employers or welfare from the government, this causes yet more inflation in a vicious cycled that can, in extreme circumstances, lead to a Zimbabwe-style hyperinflationary currency collapse.
Fortunately, central banks possess an instrument to pull the brakes on money velocity: interest rates.
If the money velocity starts to heat up, central banks can dampen it down by raising interest rates. By raising interest rates, central banks can increase the price of loans thereby reducing the demand and volume of loans (and, hence, money creation) in the economy. Raising interest rates also puts the breaks on government spending and tends to deflate property prices by making renting preferable to purchasing houses and servicing a mortgage. Higher interest rates also encourage people to save up money as cash deposits as opposed to spending it on things like luxuries, property or equities.
So, if the central bank can increase the money supply whenever they want by purchasing large amounts of debt to encourage both private lending and government spending, and slow down inflation whenever they want by raising interest rates, then it sounds like maintaining price stability is straightforward and doable – so what’s the problem?
The problem is when government debt to GDP rises above a certain threshold, the central bank can no longer raise interest rates without completely messing up the government’s budget. When government debt is through the roof, the slightest increase in interest rates forces a government to simultaneously slash public spending and raise taxes just to cover interest payments. This simultaneously cripples economic productivity, through higher taxes, while also denying critical benefits and public services – such as healthcare – to the most needy and vulnerable in society. The net result is that, in practice, once government debt to GDP rises above a certain threshold (about 77% according to the World Bank ) debt levels become a serious drag to economic growth. Beyond this debt to GDP threshold, raising interest rates becomes a less and less a practical option for a central bank.
And without the ability to raise interest rates, the central bank has no conventional monetary tools to reign in inflation. Eventually, inflation will raise the nominal GDP relative to the nominal sum of the national debt, at which point it will, once more, be possible to raise interests rates to reign in further inflation. The question as to whether this will just be a 1970s style 70% currency devaluation which stabilises after that – or a more catastrophic Zimbabwe-style currency collapse – depends on social factors that are hard to predict. Will people panic? Will there be mass unrest that requires vastly more government spending at a time when taxes are harder to raise than ever? (Remember, during uprisings and insurrections a significant fraction of the population refuses to pay tax)
If we look at the historical federal debt to GDP ratio there is reason for concern that things may turn out worse than in the 1970s. Back during the 1970s, federal debt was 20-30% of GDP. This made it feasible to curb inflation by raising interest rates to emergency levels. Today, however, federal debt to GDP is many times higher.
If you firmly believe the central banks of the world have everything under control and there is no danger whatsoever of hyperinflation, then you must reconcile that belief with the historical fact that numerous fiat currencies have collapsed, or experienced severe hyperinflation, in the past. Given that no government ever wants full-blown hyperinflation, we must conclude that, even if hyperinflation is always avoidable, there must nevertheless be certain conditions where avoiding it is at least very difficult and by no means straightforward.
To consider our current situation, let us compare the inflation rate to a horse, the central bank to the rider, raising interest rates to the reigns, and QE and other fiscal stimulus to various measures to try and get the horse to move faster. For the banking system to hold together, our inflation rate horse has to steadily plod forward, neither too fast, nor too slow. In our current situation with the COVID lockdowns, the horse has stopped, the rider is squeezing his calves against the horse’s side saying “giddy up horsey!” but our inflation rate horse is still obstinately not moving. In desperation, the rider now starts whipping the horse, thumping its backside and shouting “I SAID GIDDY UP HORSEY! COME ON! GET A MOVE ON!” but there’s a problem: the rider doesn’t have any reigns to hold onto (since high levels of government debt, prohibit any significant interest rate hikes), so if the horse suddenly breaks into a full gallop and throws the rider off, there’s very little the rider can do to slow the horse down…
…or is there?
Consumption Quotas And Progressive Consumption Tax: A Silver Bullet For Inflation
There is a much more direct and reliable way to prevent – or moderate – inflation than fiddling with interest rates, an approach that will work robustly irrespective of debt to GDP ratios or the amount of money-printing required:
A spending limit, or consumption quota.
Inflation is ultimately caused by spending. Institute a hard limit on spending and you will produce a correspondingly hard limit on inflation.
To understand why, lets go back to our price equation:
MV = PT
Spending or consumption per unit time, C, can be expressed as:
MV = C
The total money supply multiplied by the number of times money changes hands per unit time is the amount of money that gets spent per unit time.
Substituting into the first equation and making P the subject of the formula yields:
P = C/T
Where,
C = Money spent on consumption per unit time
P = price of consumer goods
T = total underlying value of consumer goods transacted
Limit the amount people can spend on consumer goods per unit time and you limit the price inflation of those consumer goods (assuming the value of goods transacted remains constant).
It’s that simple.
And this logic will hold irrespective of the quantity of money that gets printed.
You can even apply different spending limits to different classes of goods. Limiting the amount of money people can spend on cars, but not the amount on money that people spend on helicopters and you will get inflation in the price of helicopters but no inflation in the price of cars.
Money velocity is a wild card and, while interest rates can influence it, they cannot directly control it. Once money is released into the system, the amount of times it gets re-used is organically determined by human behaviour. Interest rates can influence people’s decisions, but they cannot determine them. Spending limits, on the other hand, can place hard and reliable limits on inflation rates, even in environments in where a great deal of money is printed – perhaps as a response to high levels of unemployment or some other national emergency.
Another feasible alternative to a hard consumption quota that could effectively curb inflation would be a steeply progressive consumption tax. So you would have a consumption tax-free-allowance after which you would pay an 85%-90% consumption tax on marginal consumption above that. While existing taxes like VAT and sales tax are both forms of consumption taxes, they are flat taxes rather than progressive taxes. We don’t want to discourage poorer members of society from buying what they need to buy, but we do want to discourage wealthier members of society from bidding up the price of necessities through buying more than their fair share of them. A steeply banded consumption tax system or a hard consumption quota would achieve just that, while having less of an impact on productivity, and discourage less people from working, than, say, a similar level of income tax.
With progressive consumption taxes and consumption quotas imposing hard (or slightly less hard) spending limits on various goods, a government could pretty much print as much money as they need to print to provide liquidity and fund any welfare program or public service they need to fund, without having to worry about inflation.
In times of scarcity, such as during war, the logical response is to ration out scarce resources equitably to ensure that everyone has enough while rewarding those who work exceptionally hard with a little bit more, but not so much as to deny others the basic means they need to live a tolerable life. If climate change, soil erosion, groundwater depletion, and other forms of environmental deterioration will mean that future generations will have to exist in a world where resources are scarcer and our current assumptions of continuous economic growth may no longer be possible, then rationing out those scarce resources to ensure that everyone has sufficient is the only sensible and humane approach to take.
The Economic Function Of Inflation
Although widespread high levels of inflation across-the-board do tremendous damage to the economy and society, price inflation in specific classes of goods has a useful economic function, in that it makes the production of highly desirable goods in short supply highly profitable and thus stimulates businessmen to respond by increasing their supply.
For this reason, it might be desirable to only impose spending limits on certain classes of goods and not on others whose production needs scaling up.
The Amazing Potential of Central Bank Digital Currency
Even a few years ago, the practical implementation of a progressive consumption tax, let alone spending limits, or even spending limits and progressive consumption taxes that vary depending on the category of products that people spend money on, would have been unenforceable. Until recently, there was no easy, convenient way to practically know what people spent their money on (in addition to raising personal privacy concerns).
However, central bank digital currencies could change all that. The capacity to automatically record where money is spent can be intrinsically incorporated into the ledger’s architecture. This makes spending limits, and even category dependent spending limits, very easy to enforce. Progressively-banded consumption taxes could also easily and automatically be deducted in a convenient manner free of complex paperwork or onerous forms.
Furthermore, if the process is fully automated, with no human in the loop, it might be possible to implement while preserving anonymity which could hopefully assuage privacy concerns.
The history of economic thought has been dominated by a tension between maximizing the efficiency of production and maximizing the efficiency of distribution. Price controls, and using high income taxes to fund welfare to those who most need resources, ensure the goods which society produces are distributed to those who most need them and who gain the most utility from them. However, these very same methods suppress the incentive to produce, or the proceeds of hard work, and, thus, reduce the overall availability of goods and services across society.
Conversely, in the absence of price controls and redistribution measures, such as welfare, there is a strong incentive to work and the price of goods that are in demand can freely and rapidly rise, thereby stimulating marginal production. The downside is that such price inflation caused by spending from more well off members of society can often make basic necessities unaffordable and price poorer member of society out of the market – even for necessities, such as food.
The key tension between progressivism and conservatism arises from the fact that efficiently distributing goods across society can suppress marginal production.
In many ways, central bank digital currencies could be regarded as the Holy Grail of economics, enabling prices to be suppressed at affordable levels for those who need them without suppressing the marginal production of new goods and services. This might be achieved by imposing consumption limits on legacy production, but exempting marginal production. For example, impose limits on the amount of money you can spend eating out at restaurants, but exempt restaurants that had newly opened in, say, the last two years from those same spending limits. This would let marginal producers earn a price premium over legacy producers and get through the first few rocky years of starting up from scratch. Another example might be to limit the number of houses that each person can purchase to one, or perhaps two, but to exempt new-build houses from these consumption limits. Or to limit the amount of money people can spend on meat, but to exempt farmers that managed to consistently increase the size of their heard – and so on and so forth.
You could even apply a green twist to selective spending limits. You could limit the amount that each person could spend at the petrol station per year, while exempting electricity consumption for EVs, or… even better… limit the amount people can spend on electricity (perhaps larger limits than petroleum), but exempt electric produced by renewable sources from such limits. Or allow people who install insulation and heat pumps in their houses to own more than two houses and rent them out to tenants, etc., etc., All these measures would create a price premium for green products and services while at the same time ensuring that everyone, even the relatively poor, can access the affordable legacy goods and a services they need up to their quota. When it comes to food, you could exempt foodstuff like seaweed, that don’t require freshwater for cultivation, from food spending limits, or no-till agriculture, and so on and so forth.
And because these spending limits allow money-printing without inflation, it would be fairly straightforward to fund a Basic Income sufficient to end to poverty across the board while, at the same time, creating a sufficient price premium to drive the rapid expansion of sustainable technology. Indeed basic income itself alleviates poverty in the most sustainable way possible by facilitating self-sufficiency, local economies and reducing the need to commute. Furthermore, central bank digital currencies could also promote local economies by allocating higher spending limits to goods purchased from local businesses.
By rationing legacy production, while exempting sustainable technology, CBDCs can insure that the green transition will not cause the cost of services to become unaffordable for those on low incomes and simultaneously generate a price premium that will facilitate the rapid expansion of sustainable technology, without excessively restricting the consumption of people with greater means, and enable a Universal Basic Income to be funded – all at the same time!
A Lack of Public Trust?
You may be aware of the many videos (especially from Austrian School thinkers) circulating around the internet that present central bank digital currency and universal basic income in Orwellian, almost apocalyptic, dystopian terms suggesting that digital currencies would give central planners limitless power that could be used to deny loans to people who made politically incorrect social media posts – or who criticised the government or central bank in any way – while giving bucket loads of free money to politically correct people who towed the party line and praised the establishment.
In many respects, central bank digital currency is the financial equivalent of nuclear energy. It is an immensely powerful tool which, if used correctly, could solve all our financial problems and simultaneously eliminate poverty while smoothing the transition to a sustainable future. However that same tool (like nuclear weapons), could also have disastrous consequences and usher in social credit scores and totalitarian control. It is true, that, in principle at least, one could use programmable digital currency to reward people who embraced one ideology, religion (or even of a given race) over a less favouritized group or groups. And, admittedly, the recent spate of events, such as one conservative commentator getting his insurance cancelled over his social media posts does not inspire one with great confidence in the political impartiality of our current financial system. However, it’s hard to believe that such an architecture could be programmed without someone blowing the whistle.
The answer is not to reject Central Bank Digital Currencies, which hold so much positive potential, but rather to vigorously campaign to ensure that all the code which determines how accounts get credited with money, be open source and available for all to inspect.
While it’s important to ensure that powerful technologies are used responsibly, we should not refrain from developing technologies that could accomplish great goods simply because they could also do great harm if abused.
Our current financial system is failing. It is extremely unstable and, unless replaced by something more robust prior to its complete collapse (which is bound to happen sooner or later), it will take the whole global economy down with it leading to consequences too disastrous to fathom. This is what we face in the absence of structural reform.
The price of the paralysis, resulting from a lack of trust, can be disastrous.
By the mid 1980s, nuclear energy was on a roll. Between 1975-1985 France had increased its nuclear production from supplying less than 20% to over 75% of all electricity and had just connected a 1.2GW fast breeder reactor, Superphenix to the grid in 1986. Nuclear energy was a mature and fast growing technology and there was every reason to believe that, over the next few decades, fast breeder reactors would supply most of the world’s electricity, which, while still in the prototype phase, were making rapid advances.
If such a future had materialized, there would not be no problem with global warming, or climate change, today. Furthermore, spacecraft propelled by nuclear energy, which were being actively researched back in the 1960s, would have enabled us to establish manned outposts on Mars, Venus and on the moons of Jupiter and Saturn.
We threw all that away because of public mistrust over nuclear energy; because of concern over nuclear weapons; because we didn’t trust our nuclear researchers to responsibly handle the waste output of nuclear reactors, or to design them to be safe. Because of this distrust, ironically fomented largely by the “environmental” movement, FOUR DECADES that could have been spent decarbonizing the global economy were THROWN AWAY. The nuclear industry is now a shadow of its former glory, a lot of the expertise and experience that the workforce developed building large reactor projects is now forgotten, an enormous fraction its employees are now approaching retirement and now we are caught in a mad belated rush to roll out renewable energy as Australia burns. At this point, climate change is inevitable and is happening as we speak and our only choice is whether we want catastrophic climate change or just moderately disastrous climate change. Vast swathes of Canada’s boreal forests have now been turned into black goop due to our prolonged dependence on fossil fuels.
…and all because we didn’t trust nuclear scientists to do their job back in the 80s.
If we don’t reform the existing banking system soon, the ramifications to the global supply chain will be absolutely disastrous – indeed it could precipitate the breakdown of civilization. By all means, lets have public oversight over the use of CBDCs but let us not reject this critical reform to global finance for no better reason than an intense distrust of the banking institutions that coordinate our global economy.
How can we have a civilization at all if no one trusts anyone else?
John
