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The Debt Crisis and Fiat Money

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The European Union (EU) has a sovereign-debt problem. Greek government bonds have been downgraded to junk status, and there is talk of default. Italy, Spain, and Portugal appear to be next, as they face skyrocketing interest rates just when their governments must borrow more to service their debt.

Should these countries default, some of Europe’s largest banks which are heavily exposed to EU sovereign debt could collapse. American banks have less direct exposure, but many of these institutions have sold insurance derivatives known as credit-default swaps to their European counterparts. So the U.S. financial system is more exposed than it first appears.

The solution now being proposed is to have the European Central Bank or some other institution like the International Monetary Fund conjure up trillions of euros. The new money would then be lent to the insolvent governments of the EU. This debt rollover would result in a severe devaluation of the euro, but it would take the global elites banking system off the hook and delay the day of reckoning for the welfare states of Europe.

The best summation Ive come across of the crisis in the eurozone was given by Charles Biderman, the founder and CEO of TrimTrab’s Investment Research:

European leaders are searching for a relatively quick and easy way out of the government debt bubble that has been building for decades and just started to burst a few years ago. Unfortunately, there is no quick or easy way out.

Debt has to be reckoned with one way or another. It either has to be repaid, or someone has to bear the losses on what cannot be repaid, either through default or inflation and currency debasement. If it were otherwise, everyone could be rich.

The bailouts proposed for the Eurozone do not solve the underlying solvency problem. Instead, they are little more than shell games to shift losses on bad debt from bondholders to taxpayers.

Europe’s debt problems were created by excessive borrowing. That much is obvious. But these governments were only able to borrow heavily because the prices of their bonds were kept artificially high by artificially low interest rates. Interest rates can only be kept low through the expansion of the money supply. And this inflation is only possible under a system of fiat money.

Had there been a commodity-based monetary system in place, like the gold standard, there is no way these governments could have borrowed so heavily for so long. Interest rates would have gone up as the supply of loanable funds was depleted, thus discouraging further indebtedness.

The problem is there are no longer any institutional constraints on money creation. When governments enter the credit markets, they don’t have to compete with other borrowers for a finite supply of money, because they can pay off debt by issuing paper money.

Debt monetization sets in motion the destructive process whereby overvalued sovereign debt enables governments to spend more, which creates more debt, which inevitably leads to a fiscal crisis when tax revenues are no longer sufficient to maintain the level of government spending and service of the debt. This is where the governments of Greece, Italy, Portugal, and Spain find themselves today.

The United States bears much of the blame for the European Unions sovereign-debt problem, because the U.S. dollar is the worlds dominant reserve currency. The monetary policies of foreign central banks are heavily influenced by the Federal Reserve, because they pyramid their currencies on their U.S. dollar reserves. The more dollars the Fed creates, the more money the central banks of the world create.

Fiat money has resulted in a borrowing binge that now must come to an end. The financial writer Gary North made this observation in a recent column:

This is hedge fund manager Kyle Bass’s assessment of the situation in Europe. He stated this in a rousing interview on the BBC’s TV network.

He made two crucial points points that stock market investors are ignoring. First, over the last nine years, there has been an increase of world debt from $80 trillion to $210 trillion. These numbers are staggering. Global debt over the last nine years has grown at 12% per year, while GDP has grown at 4% per year.

While he did not verbally spell out the conclusion for the interviewer, it is this: when credit must grow by 12% per year in order to produce 4% GDP growth, at some point there will not be enough GDP to supply sufficient credit.

It is time once again to quote economist Herb Stein: When something cannot go on forever, it has a tendency to stop.

While the medias spotlight is on the eurozone right now, the United States has a sovereign-debt problem that is every bit as serious as Europe’s perhaps worse, given that the U.S. government is borrowing heavily to maintain not only a domestic welfare state but also a global empire. The country’s national debt is now 100 percent of GDP and predicted to exceed 120 percent by 2015. The situation looks even bleaker when you consider that the federal governments unfunded liabilities are estimated to exceed $100 trillion ($200 trillion by some estimates).

Since Nixon closed the gold window in August 1971, there has been an explosion in credit and price inflation. The Consumer Price Index has gone up by more than 500 percent while total U.S. debt increased from $9 trillion to over $60 trillion. In that time, the country’s GDP grew from $1.1 trillion to $15 trillion. The US has borrowed $51 trillion over the last 40 years to yield an increase in annual GDP of $14 trillion.

This explosion in public and private-sector debt would not have been possible had the United States remained on the gold standard.

Some may argue the inflation was necessary to spur growth, but that is nonsense. Economic growth comes from capital investment, which is only possible if people defer consumption and save. Low interest rates discourage saving and encourage consumption. Whatever growth the U.S. has enjoyed in the last four decades has occurred despite inflation, not because of it.

The fiat-money system has created a corrupt and unstable political economy. The Feds ability to monetize government debt (inflation) has enabled the expansion of the parasitical public sector, which now appears to have overwhelmed the productive private sector.

Debt and inflation have distorted the economic structure of the country. The U.S. economy, rather than being based on production financed through equity, is now based on consumption financed through debt.

Despite the severity of the federal governments problems, the country’s political leadership still does not take them seriously. This was made clear by the failure of Congress’s so-called Super Committee to agree on a deficit reduction plan to cut $1.2 trillion in federal spending over ten years. Remember that the budget deficit for 2011 alone was $1.3 trillion. Given that level of deficit spending, cutting $120 billion annually for the next ten years will never balance the budget.

The country’s fiscal problems will not begin to be addressed until Congress stops borrowing and takes an axe to the federal budget. Congress simply needs to bring spending into line with revenue, which is around $2.3 trillion. That would require cutting spending by $1.5 trillion in a single year.

But what is mathematically simple is not necessarily politically simple. Spending cuts of that size will be politically feasible only after there is a radical rethinking of the role of government in our society. Americans would have to be willing to give up so called entitlements like Social Security, Medicare, and Medicaid, as well as the federal governments interventionist foreign policy. These programs are outrageously expensive, and there is no way the country can approach fiscal sanity while continuing with them.

Brian Moriarty of 321gold puts it succinctly:

There is $195 trillion dollars of debt in the world but only $150 trillion in assets. That assumes there isn’t trillions more of debt hidden in the $600 trillion in derivatives. I suspect the debt may be far higher than anyone anticipates today.

The debt cannot be paid, even if the entire load is dumped like bales of hay onto the backs of the taxpaying camels. The debt must be written off and governments, like corporations and families, must learn to live within their budgets. We cannot float in a sea of debt attached to an anchor of unpaid obligations.

The global economy will only truly recover when governments contract to a fraction of their current gargantuan size. So-called austerity measures need to be implemented and, most importantly, the too-big-to-fail megabanks need to be allowed to fail. These institutions are parasitical, corrupt, and obviously incompetent.

Currencies need to be stabilized within a commodity-based monetary system (i.e., gold and silver) and those institutions that devalue them must be shut down. This means abolishing central banking and introducing full-reserve free banking.

I do not expect this to happen anytime soon. The global elite are likely to resort to almost anything to preserve their central-banking and fiat-money system. Thus, we are likely to see more inflationary bailout schemes, diversionary international crises, wars, and further encroachments on civil liberties.

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    Tim Kelly is a columnist and policy advisor at The Future of Freedom Foundation in Fairfax, Virginia, a correspondent for Radio America’s Special Investigator, and a political cartoonist.