Liquidity Vortex

How credit-based fiat currency creates its own demand

With the Fed recently restarting “definitely not QE” bond purchases to inject liquidity into the system now that Reverse Repo is empty, it seems like a good time to republish this one. Expect more market hiccups and stress ahead until a real crisis provides cover for trillions in injection that will be required to inflate the next bubble.

The free-floating global fiat currency system has been operating since Nixon ended the last vestiges of the US gold standard in 1971. In the over five decades since then, there has been a steady chorus of warnings about the imminent collapse of the dollar and of fiat currency in general. In spite of all the doom and gloom, the dollar could say, like the famous Mark Twain quote, “the reports of my death have been grossly exaggerated.”

There’s a reason that, despite all its faults, fiat currency always seems to find a way to survive. Its value may be inflated away, sure, but at the end of the day the world still buys and sells, borrows and lends, spends and saves, in dollars. When the economic situation is chaotic, it becomes very helpful to understand why.

I’ve explained the structure of the banking system in other articles, so I won’t rehash all of that here.

Briefly, the fiat currency we use today, like the dollar, is a hybrid animal. It’s part fiat (base money) and part credit. Most of the “dollars” people hold are not actually fiat currency printed by the Federal Reserve. Most are in the form of bank deposits held in a checking or savings account. Those bank deposits are created out of thin air by commercial banks, in the process of making loans.

Banks don’t loan out money from a reserve they have in a vault somewhere. When they make a loan, they create two ledger items on their balance sheet. The first is the loan, which is a bank asset. It’s a ledger entry that says the borrower owes the bank a certain amount of dollars, with terms and interest. The second item is the bank deposit, which is an IOU from the bank to the borrower. It’s a ledger entry that says the bank owes the borrower a certain amount of dollars.

So by the combination of these two ledger entries, the bank creates some brand new dollars, which the borrower gets to spend. This is how our credit-based, fractionally reserved banking system works to increase the money supply. Plenty of the inflationary forces of “money printing” are a result of this commercial bank credit expansion, and not something the Fed did.

There are certain implications to creating money by this type of credit expansion. Say the bank makes a loan of $100,000. Let’s say the terms are 10 years, 10% interest rate, annual payments. So the bank creates the $100,000 out of thin air, and the borrower takes the $100,000 and spends it. For the sake of argument, let’s ignore all the other money in the economy and pretend this $100,000 is all that exists. It won’t matter in the big picture, because all the other money is created through the same process so the same principle will apply on a large scale.

At the end of year one, the borrower will have to repay $10,000 of principal to the bank, along with $10,000 of interest. When the borrower repays the $10,000 of principal, the bank’s balance sheet must shrink. The asset (the loan) goes down from $100,000 owed to $90,000 owed. The liability (the bank deposit total) also goes down from $100,000 to $90,000. So $10,000 is effectively destroyed in paying back the loan.

In order to get the $20,000 to make the loan payment, the borrower had to earn back the borrowed money, which he had initially spent upon receiving the loan. So out of total money supply of $100,000, he worked and earned $20,000 and made his annual loan payment. Now at the beginning of year two, the borrower owes $90,000, the total money in circulation is $80,000, and the bank holds a profit of $10,000. At the end of year two, the borrower pays back $19,000 dollars. $10,000 of principal, and $9,000 of interest. The total money in circulation is now $61,000, the borrower owes $80,000, and the bank holds $19,000 in profit.

Do you see the problem that’s developing? There is no longer enough money in circulation for the borrower to pay off his loan. The bank created the principal when they made the loan, but created no additional money to pay off the interest. So the borrower could earn all the money in circulation in the economy, and he still wouldn’t have enough to pay off his loan. Worse yet, every year as he makes loan payments, the amount of money circulating in the economy falls. He has to earn a higher and higher percentage of all money available, because the supply keeps falling as debt repayments destroy the money. The only way for the borrower to earn enough to finish paying off his loan, is for the borrower to work for the bank and for them to pay him back the interest they earned from him. Then, if he finally earns all the money in the economy, including the bank’s profits, he can fully pay back his loan. At that point, the amount of money in existence goes back to zero.

When we expand this situation to the global economy, we discover that the world has $320 trillion of debt and only $120 trillion of M2 money supply. The annual loan repayments on that massive debt pile are around $60 trillion.

That’s why the dollar refuses to die. Regardless how much everyone hates it, the global debt pile is enormous. And the only way to survive is to keep working and earning dollars to keep making those payments every month. And the ride never ends, because if every single dollar in existence was used today to pay down the debt, the world would be penniless and still $200 trillion in debt. That’s $25,000 of debt for every human on the planet.

So that’s how banks create their own demand, and keep an iron grip on the global economy. Every loan they make creates future demand for dollars to repay that loan. And the ever-increasing gap between the debt and the money available to repay it means that the only way for the economy to stay above water is a constant supply of new loans to create the money needed to pay off the old loans and accumulated interest. Which, of course, is supplied by the banks.

So what happens if banks decide to slow down the new loan supply? Loan repayments destroy money, the money supply shrinks, and deflation kicks in. But not the good kind of deflation, where goods and services get cheaper and wages go further. That can never happen, because the more debt is paid back, the larger the debt pile becomes in relation to the money supply. So debt repayments absorb a larger and larger share of rapidly falling incomes.

And that’s the liquidity vortex. Without a constant supply of fresh debt, all liquidity gets sucked into a black hole of debt repayments that can’t mathematically be filled.

And what happens if people just stop paying back the debt? What if they just walk away? Won’t that cause big problems for the banks? Well, take your mortgage for example. What happens if you stop paying? You soon find out that assets “owned” with debt aren’t actually yours, they’re the bank’s. If you stop making payments, the bank takes “your” house.

So the bank creates money out of thin air and loans it to you, and you buy a house. Then, if you fail to repay that loan (which is a mathematical impossibility on a global scale, because there literally isn’t enough money in existence for everyone to do that), they take ownership of the house.

Now that might leave a hole in the bank balance sheet (remember that loan asset and deposit liability they created) since the loan will have to be written down to zero while they still owe the deposit liability. So if the value of the house falls below the loan amount, the bank won’t be able to sell the house and patch their balance sheet hole. What happens then?

Well, we found out in 2008. Luckily for the banks, they own a bank cartel called the Federal Reserve, which has the ability to create fiat dollars (real fiat base money, not credit) out of thin air without going through the loan creation process like a commercial bank. So the Fed created trillions of dollars and gave it to the banks in the form of a bailout, and they didn’t have to suffer the damage of insolvency. Of course the damage wouldn’t be to the banks anyway, since their profit in the form of interest income is already spent. The damage would be to the bank depositors, who wouldn’t be able to withdraw their money from the insolvent banks. So that gives them cover to frame the bailouts as a benevolent act to “save” the depositors, rather than an easy and painless escape for the banks from the mess they created.

How does this liquidity vortex play out during times of economic uncertainty? Anytime there’s uncertainty, what’s the first concern of every economic actor? Making sure they can make their debt payments next month, for sure. The whole world is leveraged to the gills, and if they can’t make the payments next month the whole house of cards comes crashing down. So the first impulse during uncertainty is to make sure they have enough cash on hand to service debt. Maybe they have enough for next month, but what about the following month? Might be good to have a little more cash on hand, right?

So how can the whole world in aggregate increase their cash balances? I’ll save you the trouble. They can’t. It’s not possible. The money supply only increases through banks making new loans, which doesn’t help because it increases debt just as fast as money supply; or through central bank money printing, which is the last ditch attempt to stop a bloodbath. But the fact that it’s impossible doesn’t keep people from trying. So how do they try to increase cash? By selling assets, usually. That of course doesn’t work in aggregate, because every dollar earned by selling assets is a dollar taken out of someone else’s cash balance.

And what happens when everyone tries to sell assets at once? Asset prices collapse. And when the value of your assets is collapsing while your monthly debt payments are still fixed, does that make you want to hold more or less cash in reserve? And then if that liquidity vortex continues long enough, people cut back on spending because they would rather hang onto that money to provide some security that they’ll be able to service their debt through the crisis. The reduced spending squeezes business income and profits, which forces them to cut expenses and lay off employees, which reduces spending still further.

And no matter how bad the crisis gets, the mortgage bill and the credit card bill and the business line of credit are still due every month. And the harder people try to pay off the debt, the faster the money supply shrinks, and the more impossible the situation becomes. The only thing that can turn it around is a massive bailout of liquidity provided by, you guessed it, still more debt. That provides temporary relief, while setting the stage for the next, inevitable, credit and debt bubble and accompanying collapse.

And that's why the dollar keeps coming back, despite all predictions of imminent doom. It's actually a brilliant system. Horrifying, diabolical, but brilliant.

The only escape, in my opinion, is a complete monetary reset away from a debt-based currency to an equity-like store of value asset. That's the only monetary system that allows for healthy deflation without systemic failure.