The Failure of Fiat Money

The 300 year old experiment in driving the economy by creating money is over. We've overpopulated the planet and consumed most of its resources. Creating more money to incentivize higher production, or growth – whether done fairly or not -- just won't work anymore.

The Federal Reserve may for a time be able to manage a money supply appropriate more or less to a plateaued economy, even an economy as unfair as the one it maintains. But from now on any economy will be less and less able to deliver the goods and services expected by ever greater numbers of people. We face at best a long, slow squeeze, a zero-sum game with a shrinking pie. At worse we face a more acute crisis participated by some trigger event: runaway global warming, a large terrorist event or war, another major financial crash.

This time it's different. We face a true economic/ecological depression, not another financial depression, as so often in the past. Back in the 1930s, as on earlier occasions, we had a financial depression, that is, a speculative boom followed by a financial crash. At that time we still had plenty of productive resources and potential, room for population growth, and relatively few externalized costs.

The problem then was the refusal of the central banks or their equivalents to carry out any kind of quantitative easing (QE) or deficit spending when it could have worked; they choose instead to accept insolvency and liquidation on a large scale. But when the necessary stimulus came – in the form of a world war – the resources were there for the economy to rebound and debts to be absorbed. Today the potential for growth is gone. We had a classic financial crash in 2008, but few have noticed that it coincided with a profound, if slow-motion, global eco-crash. Both are still unfolding, and are now deeply intertwined.

Some recent history will be useful to understand how we got to this point:

The Fed, since the 2008 crash, has been using its power to create money to do two things: first, to recapitalize banks which otherwise would have failed, and, second, to absorb the excess debt of the US government. As a result, the big commercial banks have avoided insolvency and the federal government has been able to run continued deficits without rising interest rates.

The Fed recapitalized the banks by buying their toxic assets (mostly worthless mortgage-backed securities), and it absorbed excess US government debt by direct purchase of long-term government securities (quantitative easing). But this monetary "cure" for the financial crisis has turned out to be worse than the disease.

Buying the banks' toxic assets rewarded their moral hazard, their propensity to take risks in hopes of greater profits for themselves while deflecting the responsibility for losses onto others. Buying long-term government debt from the banks further increased their liquidity. More importantly, it guaranteed a market for Treasury bonds -- which likely would not otherwise have found adequate buyers – keeping the government solvent, but artificially so.

As a result of Fed bond purchases, interest rates on government securities, which normally would have risen to attract more buyers, were kept artificially low. These low rates were expected to encourage lending by the banks and to restimulate the economy, while minimizing interest payments on the government's rapidly expanding debt. As we can now see, six years later, the economy has not responded. Banks found far fewer borrowers than expected to put that all money to work, and the debt burden has exploded.

Unable to offload their bloated balance sheets, banks invested much of their excess cash in new speculative bubbles, especially in the equity markets which have soared to all-time highs. Although the banks not only survived but prospered, and the government has so far been able to meet its obligations, this new wealth went mostly not to the general public but to the infamous 1 percent who were able, in one way or another, to participate in the speculative bubbles unleashed by the banks.

Defenders of QE and the Fed argue that this policy averted a much greater threat of financial collapse, and that in due course economic recovery will take advantage of all that pent-up money in the financial system. A growing economic pie, as so often in the past, they tell us, will more than make up for the increased debt burden necessitated by QE, and in the end benefit all.

Critics of QE and the Fed on the other hand argue that the system is inherently designed to concentrate wealth in few hands, that the primary motive of Fed policy is to bail out the big banks and their investors, not serve the public, and, above all, that an enormous amount of new debt is being created in the process, debt that will saddle future generations of taxpayers and which seems unlikely ever to be paid off.

A growing progressive movement proposes to take monetary policy away from the Fed and put it directly under government control, either through a system of national pubic banking, or through issuance of a government-issued currency, modeled on Civil War greenbacks. Rather than prop up big banks, as in 2008, the idea is to use the money-creating power of central government in various ways to bail out individuals and deserving enterprises.

For instance, all deposits could be guaranteed, even in insolvent banks, by extending FDIC as needed. Similarly, underwater mortgages, unpayable health-care bills, onerous student loans, and out-of-control liabilities could be paid off directly by a reformed Fed or a new public bank, relieving millions of citizens of crushing financial burdens. At the same time, vast government-funded infrastructure programs could pump even more money into the economy.

Similarly, Treasury bonds purchased by the Fed could be cancelled, as suggested by Congressman Alan Grayson and others. The money paid for those bonds would be put back into circulation, without any need to continue to service those obligations. These and similar approaches, it is claimed, would put trillions of dollars of assets directly into people's pockets. Social justice would be served and the economy would be reignited.

This progressive monetary agenda puts great faith in the ability of a centralized government to act in the public interest. It presupposes that the government is reasonably accountable to the public. Given the current corruption and dysfunction in Washington, however, it is doubtful that this faith is warranted. A government-run monetary system, without drastic political reform, would almost certainly reflect the interests of lobbyists, government contractors, and other special interests. It would almost certainly end up creating an elite, perhaps every bit as exclusive as the current crop of one per centers spawned by Wall Street.

Progressives might object that even an imperfect system of financial redistribution would be better than what we have now. But they have to show how that would be so, and recent attempts at financial "reform" on the national level, such as Dodd-Frank, have conspicuously failed to break the grip of the traditional "money power."

The deeper dilemma here is that the traditional and progressive approaches both presuppose that the creation in some form of top-down fiat money will stimulate the economy. The Fed would do it through the traditional banking system, with all its flaws; the progressive critics of the Fed would do it through direct action by big government, in spite of its lack of public accountability. Unfortunately, the common assumption they share -- that we can spend our way out of financial difficulty -- no longer obtains.

There are fewer economic opportunities not because of a lack of money, but because the global economy has bumped up against the limits of growth (resource scarcity plus increasing externalized costs like pollution, climate change, overpopulation, etc.). This isn't the place to argue for the limits of growth. A vast – and to this writer, persuasive -- literature on the subject has been developed since the 1970s.

Those limits – mostly dismissed by "growth" enthusiasts -- are the real problem. And it's a problem not only for the banking system and traditional lending, as well as for government spending, but for all of us. Tragically, it would remain a problem even if debt-free fiat money were funneled directly into the hands of certain consumers, or private investors, or into government sponsored infrastructure projects. Even if such policies leveled the economic playing field, which is unlikely, they would not address the larger ecological disaster before us.

It's the difference between the Titanic going down with first class passengers getting preferential access to the lifeboats vs. everyone on the ship getting equal access to those lifeboats. Our moral preference might be for equal access, but, in the absence of well established egalitarian procedures and customs, equal access is also like to mean chaos and pandemonium. In the meantime, no matter what, the ship is going down.

If the purchasing power now locked up in big bank financial statements would have been distributed among the general population, especially those most in need, they would have had a better shot, to be sure, at claiming their share of dwindling resources. And a better infrastructure – a smart grid, a modernized rail system, renewable energy, broadband for all, etc. – would have helped as well.

In the short run, all that would have meant a better economy and a real measure of social justice. But, in the absence of real prospects for renewed economic growth, it would also, in the longer run, arguably have exacerbated the larger crisis by piling further demands on an already stressed eco-system with finite resources. The inconvenient truth, the elephant in the room, is that we have plateaued as an economy, and are headed down, how far we do not know. The kind of financial system appropriate to a drastically different kind of life has yet to be contemplated either by defenders of the status quo, or most of their critics.