Our current monetary system is based on debt. Currency is borrowed into existence in return for an obligation to pay back the currency with interest. The issuing bank does this by typing the borrowed amount into the borrower's account. In parallel, it issues a debt obligation to the borrower. This obligation is what gives the issued currency value.
When debt is paid back, the opposite happens. The debt obligation is destroyed together with the currency that it was backing.
This system works well as long as all obligations are honoured, which is only the case if investments made by borrowers make returns at or above their debt and interest payments. However, if the return on investment is below the interest rate, we end up with a problem. Currency that should have returned to the bank together with their associated debt obligations are written off as a loss. Obligations are removed but the currency remains in circulation. A portion of the circulating currency is no longer backed by debt obligations, and the currency looses its purchasing power.
Taking this from a personal level to a national level we get that a national economy must grow at least as fast as the interest rate on its collective debt in order for its currency to retain its purchasing power. If the economy grows at a rate below the interest rate, and this is mitigated by issuing more debt, we end up in a vicious cycle where the burden of interest rates becomes ever higher. If the problem is mitigated by setting interest rates lower, the currency issued will be considered cheap relative to other things, and we get price inflation. Either way, we get a weaker currency with less purchasing power.
This derives from the fact that investments are expected to grow over time. The rate at which we expect this to happen is what the interest rate needs to be for a currency to retain its purchasing power. Furthermore, economic growth has to be at or above this natural interest rate, and no amount of meddling by central bankers and financiers can alter this.
The rate at which debt is issued, together with the natural interest rate of that debt, has to mirror economic growth. Otherwise, the currency takes a hit. Issuing more debt, or artificially lowering the interest rate below its natural level, is no alternative. We have to have economic growth at or above the natural interest rate for our current system to persist. However, economic growth is currently well below the rate at which debt is growing, and purchasing power is going to suffer as a consequence.
It should be noted that neither natural interest rates nor economic growth are things that can be objectively measured without a completely free market. GDP and inflation measures are only able to estimate what the natural interest rate might be, or what the economic growth actually is. This is because both these values are based on market consensus, and a group of experts making measurements is a poor alternative to the real thing. It's therefore impossible to say exactly how much the economy is lagging debt creation or what the natural interest rate is. However, price inflation tells us that things are far from perfect.
There's only one way to save the current system without alterations, and that is by dramatically increasing productivity so that economic growth matches debt growth. Anything wasteful will have to be cut. Inefficiencies must be removed. Our entire society will have to undergo a cleansing process in which decades of waste is thrown out. But this is not going to happen. The political will is simply not there.
This means that we'll continue on the current path until things collapse under their own weight. Currencies will lose purchasing power at an accelerating rate as things get increasingly out of hand. Only then will there be political will to save whatever there's left of the system. But by that time, debt will be so enormous that there's no way to grow the economy out of the slump it's in. The only way out of the mess will be through some kind of reset.
One option will be to default on most of the debt, which would mean that the currency created through the issuance of this defaulted upon debt must also go. A new currency will be created with a conversion rate to the old currency where several zeros are removed. There also has to be a promise that the new currency will be managed more soberly than the old one. However, the trust required for this to work may not exist, in which case there needs to be some additional promise made.
The traditional promise made by issuers of currencies is that clients can convert their currency holdings into gold. That's how things worked under the classical gold standard, and there's no need to look any further for a solution to the current problem. However, this isn't going to happen any time soon because a return to a gold standard would require a lot of debt to be defaulted upon. Otherwise, holders of debt certificates will simply rush in to convert them to gold, and currency issuers will find themselves unable to pay.
Pension funds are loaded up with debt papers, and they will not be pleased if someone was to issue a decree to the effect of making all this debt null and void. A partial default is therefore more likely. Instead of defaulting on the debt, currency issuers can declare their currency linked to gold at a revised price. Instead of $1,900 per ounce, they can say that their currency is convertible to gold at $20,000 per ounce. That would prevent holders of debt papers from rushing in to convert their debt to gold. But it would also make a lot of gold owners very rich. This is therefore unlikely to happen, even if it would in fact solve the problem.
The more likely route forward is that the market will move towards the solution that policy makers are refusing to embrace voluntarily. Gold will rise towards levels where its price matches the excess debt in society. At this point, policy makers are likely to take the hint and do what they should have done anyway, namely link their currency to gold at a much higher price than what we have today, and in that way make the debt bubble go away.
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By Heritage Auctions for image, Mary Gillick for coin - Newman Numismatic Portal, Public Domain, Link
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