Cryptocurrency: Evolution of Credit, Fiat Crisis

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The Evolution Of Credit & The Growing Fiat Money Crisis

Authored by Alasdair Macleod via GoldMoney.com

After fifty-one years from the end of the Bretton Woods Agreement, the
system of fiat currencies appears to be moving towards a crisis point
for the US dollar as the international currency. The battle over
global energy, commodity, and grain supplies is the continuation of an
intensifying financial war between the dollar and the renminbi and
rouble.

It is becoming clear that the scale of an emerging industrial
revolution in Asia is in stark contrast with Western decline, a
population ratio of 87 to 13. The dollar’s role as the sole reserve
currency is not suited for this reality.

Commentators speculate that the current system’s failings require a
global reset. They think in terms of it being organised by
governments, when the governments’ global currency system is failing.
Beholden to Keynesian macroeconomics, the common understanding of
money and credit is lacking as well.

This article puts money, currency, and credit, and their relationships
in context. It points out that the credit in an economy is far greater
than officially recorded by money supply figures and it explains how
relatively small amounts of gold coin can stabilise an entire credit
system.

It is the only lasting solution to the growing fiat money crisis, and
it is within the power of at least some central banks to implement
gold coin standards by mobilising their reserves.

Evolution or revolution?

There are big changes afoot in the world’s financial and currency
system. Fiat currencies have been completely detached from gold for
fifty-one years from the ending of the Bretton Woods Agreement and
since then they have been loosely tied to the King Rat of currencies,
the dollar. Measured by money, which is and always has been only gold,
King Rat has lost over 98% of its relative purchasing power in that
time. From the Nixon Shock, when the Bretton Woods agreement was
suspended temporarily, US Government debt has increased from $413 bn
to about $30 trillion — that’s a multiple of 73 times. And given the
US Government’s mandated and other commitments, it shows no signs of
stabilising.

This extraordinary debasement has so far been relatively orderly
because the rest of the world has accepted the dollar’s hegemonic
status. Triffin’s dilemma has allowed the US to run economically
destructive policies without undermining the currency
catastrophically. Naturally, that has led to the US Government’s
complacent belief that not only will the dollar endure, but it can
continue to be used for America’s own strategic benefits. But the
emergence of rival superpowers in Asia has begun to challenge this
status, and the consequence has been a financial cold war, a
geopolitical jostling for position, particularly between the dollar
and China’s renminbi, which has increased its influence in global
financial affairs since the Lehman crisis in 2008.

Wars are only understood by the public when they are physical in form.
The financial and credit machinations between currency-issuing power
blocs passes it by. But as with all wars, there ends up a winner and a
loser. And since the global commodity powerhouse that is Russia got
involved in recent weeks, America has continued its policy of using
its currency status to penalise the Russians as if it was punishing a
minor state for questioning its hegemonic status. The consequence is
the financial cold war has become very hot and is now a commodity
battle as well.

Bringing commodities into the conflict is ripe with unintended
consequences. Depending how the Russians respond to US-led sanctions,
which they have yet to do, matters could escalate. In the West we have
comforted ourselves with the belief that the Russian economy is on its
uppers and Putin will have to either quickly yield to sanctions
pressures, or face ejection by his own people in a coup. But that is a
one-sided view. Even if it has a grain of truth, it ignores the
consequences of Putin’s military failures on the ground in Ukraine so
far, and his likely desperation to hit back with the one non-nuclear
weapon at his disposal: Russia’s commodity exports.

He may take the view that the West is damaging itself and little or no
further action is required. And surely, the fact that China has
stockpiled most of the world’s grain resources gives Russia added
power as a marginal supplier. Putin can afford to not restrict food
and fertiliser exports, blaming on American policy the starvation that
will almost certainly be suffered by all non-combatant nations. He
could cripple the West’s technology industries by banning or
restricting exports of rare metals which are of little concern to
headline writers in the popular press. He might exploit the one big
loophole left in the sanctions regime by supplying China with whatever
raw materials and energy it needs at discounted prices. And China
could compound the problem for the West by restricting its exports of
strategic commodities claiming they are needed for its own
manufacturing requirements.

While everyone focuses on what is seen, it is what is not seen that is
ignored. Commodities are the visible manifestation of a trade war,
while payments for them are not. Yet it is the flow of credit on the
payment side where the battle for hegemonic status is fought. The
Americans and their epigones in Europe have tried to shut down
payments for Russian trade through the supposedly independent SWIFT
system. And even the Bank for International Settlements, which by
dealing with both Nazi Germany and the Allies retained its neutrality
in the Second World War, is siding with the West today.

But step back for a moment to look at how broadly based the West’s
position is in a global context, because that will be a factor in
whether the dollar’s hegemony will survive this conflict. We see
America, the EU, Japan, the UK, Canada, Australia, and New Zealand on
one side. In population terms that’s roughly 335, 447, 120, 65, 38, 26
and 5 million people respectively, totalling 1,036 million, only 13%
of the world population. This point was made meaningfully by the
Saudis who now want to talk with Putin rather than Biden. As long ago
as 2014, this writer was informed by a director of a major Swiss
refinery that Arab customers were sending LBMA 400-ounce bars for
recasting into Chinese four-nine one kilo bars. The real money saw
this coming at least eight years ago.

Even if the US’s external policies do not end up undermining the
dollar’s global status, it is becoming clear that the King Rat of
currencies is under an existential threat. And the Fed, which is
responsible for domestic monetary policies, in conjunction with the
Biden administration is undermining it from the inside as well by
trying to manage a failing US economy by accelerating its debasement.

A betting man would therefore be unlikely to put money on a favourable
dollar outcome. Whether the dollar suffers a crisis or merely an
accelerated decline, just as Nixon changed the world’s monetary order
in 1971 it will change again. That the current situation is
unsatisfactory is widely recognised by multiple commentators, even in
America, calling for a financial and currency reset. And it is
assumpted that the US Government and its central bank should come up
with a plan.

There are two major problems with the notion that somehow the deck
chair attendant can save the ship from sinking by rearranging the sun
loungers.

    The first error is insisting that money is the preserve of only
the state and is not to be decided by those who use it. It was the
underlying fallacy of Georg Knapp’s State Theory of Money published in
1905. That ended with Germany printing money to arm itself in the hope
that it would win: it didn’t and Germany ended up destroying its
papiermark.

    The second error is that almost no one understands money itself,
as evidenced by the whole financial establishment, from the
governments down to junior fund managers, thinking that their
currencies are money. Commentators calling for a reset are themselves
in the dark.

Events will deal with the fallacies behind the State Theory of Money
and whether it will turn out to be an evolution or revolution. But at
least we can have a stab at explaining what money is for a modern
audience, so that the requirements and conditions of a new currency
system to succeed can be better understood.
What is money for?

The pre-Keynesian classical economic explanation of money’s role was
set out in Say’s Law, otherwise known as the law of markets.
Jean-Baptiste Say was a French economist, who in his Treatise on
Political Economy published in 1803 wrote that,

    “A product is no sooner created than it, from that instant,
affords a market for other products to the full extent of its own
value.”

And

    “Each of us can only purchase the productions of others with his
own productions — and so the value we can buy is equal to the value we
can produce. The more men can produce the more they will purchase.”

Money or credit is the post-barter link between production and
consumption facilitating the exchange between the two. What to produce
and what is needed in exchange is a matter for those involved in
individual transactions. And the medium of exchange used is a decision
for each of the parties. They will tend to use a medium which is
convenient and widely accepted by others.

Say’s Law was incorrectly redefined and trashed by Keynes to “…that
the aggregate demand price of output as a whole is equal to the
aggregate supply price for all volumes of output is equivalent to the
proposition that there is no obstacle to full employment.” This has
subsequently been shortened to “supply creates its own demand”.
Keynes’s elision of the truth was leading to (or was it to justify?)
his erroneous invention of mathematical macroeconomics. It is simply
untrue.

All Say was pointing out is we divide our labour as the most efficient
means of production for driving improvements in the human condition.
That cannot be argued with, even by blinkered Keynesians. Money, or
more correctly credit has two roles in this division of labour. The
first is as the medium for investment in production, because things
must be made before they can be sold and there are expenses in the
form of presale payments that must be made. And the second is to act
as the commonly accepted intermediary between the sale of products to
their buyers. Instead of opining that supply creates its own demand,
if we say instead that people make things so they can buy the products
and services they don’t make for themselves, it is so obviously true
that Keynes and his self-serving theories don’t have a leg to stand
on. And importantly, full employment has nothing to do with it.

The money involved is always credit. Even the act of lending gold
coins to an entrepreneur to make something is credit because it is to
be repaid. If gold coins are the payment medium between production and
consumption, they are the temporary storage of production before it is
spent. In this very narrow sense, they represent the credit of
production which will be spent. The principal quality of gold, which
when it is at rest is undeniably money, is that it has no counterparty
risk and is to be parted with last.

The point is that money in circulation is a subsection of wider credit
and is the very narrowest of definitions of circulating media. But
even under a gold standard, it is hardly ever used in transactions and
rarely circulates. This is partly due to a Gresham’s Law effect, where
it is only exchanged for inferior forms of credit as a last resort,
and partly because it is less convenient than transferring banknotes
or making book entries across bank ledgers. By far the most common
forms of circulating media are credit in the form of banknotes issued
by a central bank, and transferable credit owed by banks to
depositors.

But in our estimate of a practical replacement of the current fiat
currency-based system, we must also acknowledge that credit is far
broader than that recorded as circulating by means of the banking
system. We are increasingly aware of the term, “shadow banks” most of
which are pass-through channels of credit rather than credit creators.
But doubtless, there is expanded credit in circulation originating
from shadow banks, the equivalent of officially recorded bank credit,
which is not captured in the money supply statistics. But there are
also wider forms of credit in any economy.
Defining credit

To further our understanding of credit, we must define the fundamental
concept of credit:

    Credit is anything which is of no direct use, but which is taken
in exchange for something else, in the belief or confidence that we
have the right to exchange it away again.

It is the right to a future payment, not necessarily in money or
currency. It is not the transfer of something, but it is a right to a
future payment. Consequently, the most common form of credit is an
agreement between two parties which has nothing to do with bank credit
per se.

Bank credit is merely the most obvious and recorded subset of the
entire quantity of credit in an economy. And the whole world of
derivatives, futures, forwards, and options, are also credit for an
action in time, additional to bank credit. Global M3 money supply is
said to be $40 trillion equivalent, about 3% of investments,
derivatives, and cryptocurrencies, all of which are forms of credit:
rights and promises to future payments in credit or currency. And this
is in addition to private credit agreements between individuals and
other individuals, and between businesses and individuals, which are
extremely common.

The commonly stated position among sound money advocates of the
Austrian school is that bank credit should be replaced by custodial
deposit-taking banks and separate arrangers of finance. But given the
broad definition of credit in the real world, eliminating bank credit
appears untenable when individuals are free to offer multiple amounts
of credit and the vast bulk of credit creation is outside the banking
system.

Consider the case of a bookie accepting wagers for a horse race. Ahead
of the event, he takes on obligations many times the capital in his
business, in return for which he is paid in banknotes or drawings on
bank credit by his betting customers. When the race is over, he keeps
the losers’ stakes and is liable for payments to holders of the
winning bets. He has debts to the winners which are only extinguished
when the winners collect. While there are differences in procedures
and of the risks involved, in principal there is little difference
between a bookie’s business and that of a commercial bank; they are
both dealers in credit. Arguably, the bookie has the sounder business
model.

The restriction imposed on an individual providing credit to others is
his potential liability if it is called upon. The unfairness in the
current system is not that bank credit is permitted, but that is
permitted with limited liability. Surely, the solution is to ensure
that all providers of credit are responsible for the risks involved.
Licenced banks and their shareholders should face unlimited liability.
It is even conceivable that listed capital in an overleveraged bank
might trade at negative values if shareholders face a risk of
unlimited calls on their wealth. That should promote responsibility in
bank lending. It will not eliminate the cycle of bank credit expansion
and contraction, but it will certainly lessen its disruptive impact.
Variations in the purchasing power of a medium of exchange

A proper consideration of credit, the all-embracing term for mediums
of exchange to include future promises, shows that government
statistics for money supply are a diminishingly small part of overall
credit in an economy. We must take this fact into account when
considering changes in the official quantity of money on the
purchasing power of units of the medium of exchange (that is credit in
the form of circulating banknotes and commercial bank credit — M1, M2,
M3 etc.).

A downturn in economic activity must be considered in the broader
sense. If, for example, I say to my neighbour that if he arranges it,
I will cover half the cost of fencing the boundary between our
properties, I have offered him credit upon which he can proceed to
contract a fencing supplier and installer. However, if in the interim
my circumstances have changed and I cannot deliver on my promise, the
credit agreement with my neighbour is withdrawn and the fence might
not be installed.

A father might promise his son an allowance while he attends
university. That is a credit agreement with periodic drawdowns lasting
the course. Later, the father might promise help in buying a property
for his son to live in. These are promises, whose values are
particular and precarious. And they will be valid only so long as they
can be afforded. If there is a general change in economic conditions
for the worse, it is almost certainly driven more by the withdrawal of
unrecorded credit agreements between individuals and small businesses
such as corner shops, and not directly due to bank credit contraction.

An appreciation of these facts and of changes in human behaviour which
cannot be recorded statistically explains much about the lack of
correlation between measures of credit (i.e., broad money supply) and
prices. The equation of exchange (MV=PQ) does not even capture a
decent fraction of the relationship between the quantity of credit in
an economy and prices. Our understanding of the wider credit scene
goes some way to resolving a mystery that has bedevilled monetary
economists ever since David Ricardo first proposed the relationship
over two centuries ago. In theory, an increase in the quantity of
measurable credit (that is currency in the banking system) leads to a
proportionate increase in prices. Even allowing for statistical
legerdemain, that is patently not true, as Figure 1 illustrates.

Figure 1 shows that over the last sixty years, the broadest measure of
US dollar money supply has increased by nearly seventy times, while
prices have increased about nine. The equation of exchange explains it
by persuading us that each unit of currency circulates less so that
the increase in the money quantity somehow leads to less of an effect
on prices. This interpretation is consistent with Keynes’s denial of
Say’s Law. The Law tells us that we all make profits and/or earn
salaries, which in the time-space of a year means we can only spend
and save once. That is an unvarying velocity of unity. Instead, the
mathematical economists have introduced a variable, V, which simply
balances an equation which should not exist.

That is not to say that credit expansion does not affect the
purchasing power of a currency. Logic corroborates it. But an
understanding of the true extent of credit in an economy confirms that
the sum of currency and recorded bank credit is just a small part of
the story – only one eighth as indicated by the divergence between M3
and consumer prices — all else being equal.

It brings us to the other driving force in the credit/price
relationship, which is the public acceptability of the currency.
Ludwig von Mises, the Austrian economist, who lived through the
Austrian inflation in the post-WW1 years and whose advice the Austrian
government was reluctant to accept, observed that variations in public
confidence in the currency can have a profound effect on its
purchasing power. Famously, Mises described a crack-up boom as
evidence that the public had finally abandoned all faith in the
government’s currency and disposed of all of it in return for goods,
needed or not.

It leads to the sensible conclusion that irrespective of changes in
the circulating quantity, the purchasing power is fully dependent on
the public’s faith in the currency. Destroy that, and the currency
becomes valueless as a medium of exchange. If confidence is
maintained, it follows that the price effects of a currency debasement
may be minimised.

This brings us to gold coin. If the state backs its currency with
sufficient gold which the public is free to obtain on demand from the
issuer of the currency, then the currency takes on the characteristics
of gold as money. We should not need to justify this established and
ancient role for gold, or silver for that matter, to the current
generations of Keynesians brainwashed into thinking it’s just old hat.
Though they rarely admit it, central bankers fully committed to their
fiat currencies still retain gold reserves in the knowledge that they
are no one’s liability; that is to say, true money while their
currencies are simply credit.

Given what we now know about the extent of credit beyond the banking
system and the role of public confidence in the currency when it is a
credible gold substitute, we can see why a moderate expansion of the
currency need not undermine its purchasing power proportionately.
While the cycle of bank credit expansion and contraction leads to the
boom-and-bust conditions described by Von Mises and Hayek in their
Austrian business cycle theory, the effects on prices under a gold
standard do not appear to have been enough to destabilise a currency’s
purchasing power. Figure 2 illustrates the point.

Admittedly there are several factors at work. While the increase in
the quantity of currency in circulation was generally restricted by
the gold coin standard, the bank credit cycle of expansion and
contraction led to periodic bank failures. Then as now, the quantity
of bank credit relative to bank notes was eight or ten times, and so
long as the note-issuing bank remained at arm’s length from the
tribulations of commercial bank credit the overall price effects were
contained.

Britain abandoned the gold standard in 1914, and just as the
abandonment of the silver standard in the 1790s led to an increase in
the general price level, a dramatic increase occurred during the First
World War. This was due to deficit spending by the state driving up
material costs at a time when imported factors of supply were limited
by the destruction of merchant shipping.

The end of the war restored the supply/demand balance and saw a
reduction in military spending. Prices fell and then stabilised. A
gold bullion standard at the pre-war rate of exchange was
re-established in 1925, only to be abandoned in 1931. The Second World
War and subsequent lack of any anchor to the currency led to an
inexorable rise in prices before America abandoned the Bretton Woods
Agreement in 1971. And since then, the sterling price of gold has
risen even further from £14.58 when the Agreement ceased to £1,470
today. Measured in true money the currency has lost over 99% of its
purchasing power over the last fifty-one years.

Both logic and the empirical evidence point to the same conclusion:
price stability can only be achieved under a working gold coin
standard, whereby ordinary people can, should they so wish, exchange
banknotes for coin on demand. Despite making up most of the
circulating medium, fluctuations in bank credit then have less of an
effect on prices, for the reasons stated above.
Can cryptocurrencies replace gold?

The reason gold is relatively stable in purchasing power terms is that
through history, above ground stocks have expanded at similar rates to
population growth. A very gradual increase in gold’s purchasing power
comes from manufacturing, technological, and competitive production
factors. In other words, the price stability clearly demonstrated in
Figure 2 above between 1820—1914 is evolutionary.

Whether cryptocurrencies or central bank digital currencies might have
a stabilising role for prices in future is highly contentious. We can
readily dismiss yet another version of state-issued currencies as
being a worse form of credit than failing fiat currencies. The aim
behind them is communistic, to enable the state to allocate credit
resources wherever and to whomsoever its political class may desire.
It is with the intention of reducing the vagaries of human action on
the state’s intended outcome. Just as every replacement currency for
failing fiat in the past has failed, if CBDCs are introduced they will
fail as well. It is unnecessary to comment further.

Cryptocurrencies, particularly bitcoin, are seen by a small minority
of enthusiasts as the money of the future, being outside the state’s
printing presses. But as observed above, in reality, sound money is
augmented by fluctuating quantities of credit in far larger
quantities. So long as sound money provides price stability,
circulating credit inherits those characteristics.

Bitcoin, the leading claimant to being future money, lacks both
world-wide acceptance and the flexibility required for long-term
stability and therefore economic calculation. Imagine an entrepreneur
planning to invest in production, a project which from the
drawing-board to final sales takes several years. His nineteenth
century forebears had a reasonable idea of final prices, so could
calculate costs, sales values, and therefore the interest cost of the
capital deployed over the whole project to leave him with a profit. No
such certainty exists with bitcoin because final prices cannot be
assumed. Furthermore, central banks do not have bitcoin as part of
their reserves, and by embarking on plans for their own CBDCs have
signalled that they will not have anything to do with it. But in most
cases central banks or their government treasury ministries possess
gold bullion, which as a last resort they can deploy to stabilise a
failing currency.

While there will undoubtedly be future benefits from their underlying
technologies, it is impossible to see how cryptocurrencies can have a
practical role in backing wider credit.
Conclusion

The evolution of fiat dollars which dates from the abandonment of the
Bretton Woods Agreement is coming to an inevitable conclusion: fiat
currencies come and go and only gold goes on forever. Whoever wins the
financial battle now raging with increasing intensity over commodity
prices, the US dollar as the King Rat of fiat currencies is losing its
assumed superiority over the renminbi, and possibly the rouble if the
Russians can stabilise it. The old-world population backing the dollar
is heavily outnumbered by the newly industrialising Eurasia as well as
its commodity and raw material suppliers in Africa and South America.

Not mentioned in this article is the Federal Reserve Board’s
commitment to sacrifice the dollar to support financial values — that
ground has been well covered in earlier Goldmoney articles. But it is
a repetition of John Law’s policies in 1720 France, now underway to
stop the global financial bubble from imploding. And just as the
Mississippi Company continued after 1720 when the French livre
collapsed entirely that year, we see the same dynamics in play for the
entire fiat currency system today.

John Law’s policies of credit stimulation for the French economy were
remarkably like those of modern Keynesians. This time, the expansion
of money supply on a global basis has been on an unprecedented scale,
encouraged by the subdued effect on prices measured by
government-compiled consumer price indices. Undoubtedly, much of the
lack of price inflation is down to statistical method, but from Figure
1 we have seen that over the last sixty years the quantity of currency
and credit captured by US dollar M3 has grown about seven and a half
times more rapidly than prices. We have concluded that this disparity
is partly due to not all credit in the economy being captured in the
monetary statistics.

Understanding the relationship between money which is only physical
gold coin, currency which is bank notes and credit which includes bank
credit, shadow bank credit, derivatives, and personal guarantees, is
vital to understanding what is required to replace the fiat-currency
system. It also explains why a relatively small base of exchangeable
gold coin in relation to the overall credit in an economy is
sufficient to guarantee price stability.