|An article written in May 2022 summarizing the basic falsity of our financial system, and the present trend toward hyper-inflation (edited Nov. 2023)
Simon Sheppard explores basic economics
A celebrated story exists from the German inter-war era, circa 1920-1930, when hyper-inflation raged. The Reichmark had so devalued that the banknotes which comprised a worker’s pay had become too heavy to carry, so one employee took a wheelbarrow to collect his wages. Stopping on his way home to buy some vegetables, the man parked his wheelbarrow outside the shop and went inside. He emerged a few minutes later to find a pile of banknotes on the pavement. A thief had stolen his wheelbarrow and left his cash!
There are pictures of children during this period using bundles of banknotes as toy building bricks. The rate of devaluation had got so bad that customers at a restaurant would negotiate the cost before eating, because by the end of the meal the price would have risen. Similar hyper-inflation occurred more recently in Zimbabwe (formerly Rhodesia), where it became cheaper to use banknotes for toilet paper and toilet paper was almost impossible to obtain. A bus fare from work in the evening cost more than it had that morning.
Such are the effects of hyper-inflation. But how does it arise? To understand this we need to recall the original definitions of the words we use, because many words have been redefined to no longer mean what they are supposed to mean. While many have heard of the hyper-inflationary periods in history such as the time of John Law in France and the German period quoted above, even many Economics graduates are unacquainted with the basic financial concepts detailed here.
For a start, prices do not inflate, they increase. The original and proper definition of inflation is an expansion of the money supply. An increase in prices is merely a consequence of that. An ‘inflation rate’ (price increases) of 5% annually means that the people’s savings are worth 5% less – buy 5% less goods – at the end of the year than at the beginning. Prices have not gone up so much as the value of the money has gone down. Money has been created, added to the supply and that has diluted the money already in circulation.
How is creating money even possible? Because what we commonly call money is not really money, not any more. Up until 1914, a one-pound coin was called a sovereign and made of gold. British coins in circulation such as florins and half-crowns really did contain silver. Over the pond, the dollar was originally a fixed weight of silver, with silver having an established price ratio to gold. Containing precious metals, these coins were real money, with inherent value. As a last resort the coins could be melted down and used as a source of the useful metals they contained.
Banknotes began as receipts for deposits of gold and silver. Nowadays what we call “money” is not real money at all. That is how the supply of it can be increased by simply printing it, or more usually, making an entry in a ledger. Debts and credits are created with the press of computer keys, which is only possible because we have ‘fiat currency.’ The word fiat is derived from the Latin factum or ‘thing done’ which basically means that the value of the currency is what the government says it is. Ultimately, the legitimacy of the currency is that the government accepts it in payment of taxes. A better word for the promissory notes which the government issues might be scrip.*
Governments cannot create gold and silver out of thin air so the temptation to employ fiat currency becomes irresistible, especially when they want to finance a war or further a particular agenda. In fact almost all of government power now derives from the ability to create “money” out of nothing. Cash to pay for foreign wars, police, prisons, propaganda and so on is effectively created out of thin air and without having to ask the taxpayer to pay for it all. The power to create scrip enables the government to assume responsibilities and take powers unto itself for which it has neither mandate nor authority.
Governments have succumbed to the temptations of fiat currency and have run up debts so huge that they defy comprehension. Some years ago it was revealed that the interest paid on the UK national debt was £100 million per day, and the time is approaching when the tax raised will not even cover the interest on the debt. More borrowing will be required simply to service the debt. Governments are so profligate that money is borrowed to give away in foreign aid.
To appreciate the enormous sums involved, consider that £500 in new £50 notes is roughly 1mm thick. Then a million pounds would be a pile about 2 metres high. A trillion (1012) pounds would be two million metres or approximately 1,250 miles high. It is inconceivable that the trillions in UK and US debt will ever be repaid.
Negative interest rates turn reality upside-down in a different way: a lender pays the borrower to use his money. Such lunacy can only exist in the bizarro world of central banks and artificial currency creation. Interest rates express the amount of risk and the value of time, so a negative interest rate says: “The risk is zero and time is worth less than nothing.” Negative interest rates were openly declared by the Japanese central bank and some European banks, but any interest rate which is less than the rate at which prices increase is effectively negative.
The creation of scrip, that is inflating the money supply, is really a hidden form of taxation. Each iteration of this process reduces the value of the notes already in circulation. Hence in the 1960s an ordinary working man could buy a house with a ten-year mortgage; his wife did not need to work. Now, both man and wife must work and commit to a 25 or 30-year mortgage. While we have wondrous new amenities like mobile phones, the internet, big screens and a countless number of TV channels, our actual wealth has fallen.
Neither is the creation of money confined to central banks. Even high street banks routinely create credit in the system known as fractional reserve banking. In this, typically 10% of a bank’s deposits are held in reserve while the other 90% is issued as interest-bearing loans. The 90% loaned will shortly find its way back to a bank, and that bank will itself only keep 10% in reserve. After only six iterations of this, a bank has been able to make loans of five-fold the original deposit. The only way to avoid this circular system is to borrow money from a bank and store it, for example under a mattress. The fractional reserve system relies on the depositors not all asking for their money back at the same time, which is why a bank run is so disastrous: it is not that the money is tied up in property or other illiquid assets, the secret is that the money does not exist at all.
For hundreds of years in Britain usury was forbidden by the Church. The original definition of usury is making money from money, which is what interest is. Money is not a good, it is a measure. But distorting the measure has such great advantages that the temptation to do so is overwhelming. Today usury is rampant and practically every word of importance has had its meaning corrupted. In addition to public debt there are insolvent pension funds and massive private debts such as corporate bonds. Calls, puts and all manner of derivative trades are made in a highly leveraged financial system. Several quadrillion (1015) dollars exist in derivative contracts, much of it apparently on Deutsche Bank’s books.
This situation is unsustainable; while it is possible to conjure fiat currency out of thin air, it is not possible to create wealth out of nothing. Wealth so produced is as notional as the “money” which purchased it. Sooner or later the bill will come due.
In past times the conditions which led to hyper-inflation were limited to one country at a time. France, Germany, the US, Argentina and Zimbabwe have all experienced financial upheaval at one time. In the present day however, the conditions which give rise to hyper-inflation are occurring simultaneously all over the world. Many countries are engaged in a ‘race to the bottom’ as they seek to exploit the advantages of creating currency while it retains some value. For example, the Swiss central bank bought 5% of Apple Corp., which it achieved simply by creating Swiss Francs for that purpose.
Additionally, any significant failure could start a domino effect and cause the entire financial system to crumble. Proponents of sound money are astonished that this unsustainable state of affairs has lasted as long as it has, but there are ‘plunge protection schemes’ and all manner of manipulations taking place behind the scenes to keep the financial system limping along. Salient among these is artificially low interest rates. The normal means of arresting an inflationary spiral is to raise interest rates, as Paul Volker did during the Reagan years, but the debts are now so huge that a significant increase in interest rates would lead to mass bankruptcy.
We have been conditioned by a steady diet of Hollywood disaster films to think of collapse as a momentous affair, following a critical event such an asteroid hitting the earth or a volcano erupting. It is certainly true that crisis can occur suddenly, but some events do not feature daring heroics and dramatic adventures for a thrilling ninety-minute cinema show. One famous wag described going bankrupt: “Slowly at first, then all of a sudden.” Financial collapse is likely to be less of an event than a process, and that process is already underway.
* Scrip describes subscription receipts, provisional or supplementary certificates issued to existing shareholders. On the basis that we are shareholders in our nation’s wealth, the definition stands.