Everyone's A Creditor

Whether You Like It Or Not

The essence of human existence is the pursuit of values. As value-producing, value-seeking economic actors, every day brings with it a vast array of choices as to what values we might offer and what values we might seek. In a free society, our value choices ought not to be subject to acts of coercion. But thanks to the prevalence of altruist ethics in our culture and its political corollary, central planning, freedom of choice is becoming a rare commodity. Depending on where one lives, there may be no choice in what wage an employer must pay and what wage an employee is free to accept; a home builder may have limited choices in how a house must be built; a farmer may have no choice in what price to accept when marketing a commodity. The list of such limitations grows by the day.

The coercive limitation of value seeking has become so ingrained in our culture, for such a long time, and on a wider and wider range of human action, that this has led to the phenomenon of people barely realizing such limitations when they experience them. These limitations have become so normalized that people express disbelief when confronted with them.

One of the most destructive restrictions on value seeking, and perhaps the most destructive of all, can be found in one of the most critical areas of economic life: the capital markets and the monetary system itself. The importance of capital markets cannot be underestimated. These markets exist to facilitate the exchange of value between savers who possess capital and entrepreneurs who deploy that capital in a productive, value creating business. Without those markets, the division of labour would be rendered impossible and humanity would be condemned to a subsistence lifestyle. For this reason, the exchange of value in capital markets needs to be as free and unfettered as possible. Every roadblock, false signal, or instance of fraud represents a threat to the workings of the division of labour.

A productive capital market rests on one very basic choice: the choice to be a creditor or not to be a creditor; the choice to deploy one’s savings for investment or, alternatively, to withdraw them from the pool of credit entirely. The alternative is to be coerced into extending credit with the only choice being to whom one wishes to extend that credit to. Though few realize it, this is precisely the situation that faces everyone currently involved in our fiat currency system.

Gold and Credit

In order to understand the previous point, it’s necessary to examine the functioning of the capital markets and the monetary system in the days of a gold standard. At that time it was actually possible, and indeed normal, to withdraw one’s consent to extend credit. The act of withdrawal, unlike today, had a noticeable and immediate impact on the monetary system. The right to withdraw credit acted as a critical safety valve to maintain investment discipline and limit the loss of capital in a monetary system.

The foundation of a gold standard rested on the deposit of a tangible commodity such as gold into a bank. Upon deposit, the gold would be added to the bank's balance sheet and could be lent out on your behalf for the purchase of productive asset. The depositor agreed, voluntary, to be a creditor to the bank and was entitled to earn interest in return for allowing the bank to invest the money. Investments could take the form of an interest bearing time deposit or perhaps a chequing account. The rate of interest would vary depending on the length of the time deposit, with chequing accounts earning the lowest amount of interest, understandably, as the amount on deposit could vary substantially. Another option was for the depositor of gold to withdraw banknotes, denominated in a weight of gold but paying zero interest, to be used for making purchases. The development of chequing and bank notes eliminated the need to carry physical gold on one’s person all the time, or to have to store it in a less secure location than a bank. No matter which option you chose, your gold remained in the possession of the bank. No matter whether you wrote cheques or carried banknotes, the depositor faced an inescapable fact: with another party in control of your gold you were exposed to counter party risk.

If a depositor did not wish to be exposed to counter party risk, you could demand that your gold be returned to you. This could be as simple as handing over the banknotes in return for your gold, liquidating your chequing account, converting a time deposit into gold upon maturity, or instructing the bank to liquidate your deposits by selling the bonds that your gold was invested in. The asset would be removed from the bank’s balance sheet and any banknotes removed from circulation. The previous credit relationship would thus be extinguished. Possession of physical gold is the true definition of “cash”; i.e. the possession of a tangible, measurable financial instrument without counter party risk.

Once one’s gold was removed from the banking system, it was still possible and routine, in fact, for trade and commerce to continue by exchanging gold coins for goods. There was no legal or tax penalty for doing so. So even if one stepped outside a formal banking system, many options for conducting nearly frictionless commerce that did not require assuming the role of a creditor. This changed over many decades as the option of conducting trade with physical gold was throttled and then eliminated altogether.

Cash Becomes Credit

As gold was replaced with fiat currency the right to withdraw consent to be a creditor and eliminating all counter party risk was gradually ended. The creditor relationship between a saver and a lender was effectively made mandatory. While it is true that a credit relationship in fiat still takes the form of a bond, or a legal contract between a lender and a borrower for the extension of credit, there is one very crucial difference: a fiat bond is irredeemable. There is no means by which the bond can be liquidated and converted into a physical commodity (gold) for the purpose of final payment to the creditor. Absent the possibility of final payment, the monetary system becomes a gigantic pyramid of perpetually recirculating bonds in which, thanks to the mechanism of compounding, the interest burden must grow exponentially.

Today, of course, no one deposits gold into a bank account. What is deposited instead are bonds of varying maturities and yields. These bonds are neither denominated in, nor backed by, a physical commodity like gold, but rather by a promise to pay, in perpetuity. Your choice is not between whether you want to enter into a credit relationship or not, but is instead solely a matter of choosing which credit relationship you prefer. Your choices are limited to the extension of credit to an entrepreneur, a bank or other financial institution, the treasury department of some government or, finally, a central bank. The fact that your bond is deposited into a bank means that you are automatically a creditor to the bank just as one was a creditor to a bank when depositing gold. There is a crucial difference, however: in a fiat system there is no practical way of withdrawing your credit that would have any impact on the behaviour of the players in the monetary system.

No one would dispute that to place one’s capital in a term deposit, a government bond or an equity account is to be a creditor. Capital deposited into a bank account and loaned out to others presents a risk of loss, which is why some sort of risk premium, or interest, is demanded on the part of the depositor.

As was the case under the gold standard, the holder of a bank account can opt to place one’s capital in time deposits or in a chequing account for a much lower rate of interest. They can also demand that their deposit be converted into bank notes of various denominations which pay no interest at all. But that is where the similarities end. Today, most people believe that conversion of a bond into bank notes, or what is erroneously called “cash”, signifies the withdrawal of one’s consent to be a creditor. Most also believe that the demand for bank notes as opposed to term deposits exerts a noticeable influence on the behaviour of the banks and the fiat monetary system. Unlike under a gold standard where the withdrawal of gold impacted the rate of interest, no such impact occurs today. Interest rates are now determined in a closed loop system characterized by the perpetual rolling of bonds. Simply put, the bank really doesn’t care if you want your bank notes.

The reason the bank doesn’t care is that the very existence of a bank note signifies an unalterable tie between the bank note and the bond from which it originated. It is simply a derivative of a bond; a coupon of a bond which pays no interest. Unlike under a gold standard, there is no way for a depositor to force the removal of the bond from a bank balance sheet. The credit relationship remains no matter what the holder of the bank note does with his notes. The final option of transacting with actual cash; i.e. carrying on frictionless trade with a tangible, measurable physical commodity such as gold coins, is simply not available.

In response to this, some may claim that they can move outside this system by trading fiat bank notes for gold. While it is true that you would not be a creditor at that point, it’s important to acknowledge what happens to your bank notes. At no time can they be redeemed in any way that would remove them from circulation in the monetary system or from a bank balance sheet. The seller of the gold (or any other good exchanged for fiat bank notes) must inevitably re-deposit the bank notes. Whoever deposits them is now a creditor by virtue of being in possession of the bond and its derivatives. Your efforts to rid yourself of the fiat bond haven’t actually extinguished the credit relationship created by the bond. All you have done is shift the burden of being a creditor to someone else.

Another issue with fiat is that without access to some form of it, you are effectively locked out of the credit system. Recall that under a gold standard, individuals could transact using gold coins without friction. Today, transactions using gold will be taxed as if the gold had been exchanged for fiat, even if no such exchange took place, thus introducing significant friction and loss of value. This overt loss of value does not exist when one transacts in fiat. Not only that, but there is currently no formal way to lend and borrow gold on a significant scale. In fiat, your only real choice is this: if you wish to access credit at all, you must participate in a system where the coercive extension of credit creates an exponentially rising debt doom loop that all must shoulder the burden of.

Even if one is willing to forgo all access to credit by the literal hoarding of fiat bank notes, this can only be temporary. The serial numbers on the notes eventually expire and they become worthless. It is inevitable that they would re-enter the banking system long before that happened. In a gold standard, it was possible for savers to send a price signal to banks that the return on investment was not worth the risk of being a creditor by redeeming their bonds and bank notes for gold. A system of coercive credit, on the other hand, entails that savers have no means whatsoever to send such a price signal to the banking system.

While it is also possible to trade with others completely outside the current banking system by engaging in barter, the opportunities for doing so successfully and over the long term are extremely limited. Few people outside of subsistence communities are willing to engage in such cumbersome practices. To those who suggest that barter is the answer to fiat, mass departure from a fiat credit system without replacement of that system with a gold standard would be disastrous. The existence of long term credit is absolutely essential for the maintenance of a division of labour economy. Mass starvation would be the consequence as it is completely impossible for the current population to ever sustain itself by means of subsistence living.

I Want My Money!

As it stand, the history of fiat is littered with instances of balance sheet implosions at a myriad of financial institutions. These events arise when credit is extended beyond what the borrowers can manage to repay, thanks largely to the inherent instability of interest rates and the resultant gyrations in asset values. So far, the resultant capital losses have been staunched, particularly in the last 40 years, by the progressive collapse of interest rates. When breakdowns occur, we often witness the spectacle of large numbers of depositors demanding the conversion of all of their bonds into zero interest coupons for immediate withdrawal. This can create a bank ‘run’ where the bank has to liquidate all of its bonds to satisfy the demand for bank notes. Such events occur more frequently than people would like to believe, particularly in poorer, less developed parts of the world. We saw this in Cyprus in 2012. The response of the banks was the same as it has always been: the severe limitation and even prohibition of withdrawals. The destruction of the bank’s balance sheet is suspended by legally barring depositors from demanding the liquidation of their bond portfolio.

People usually have a difficult time understanding why depositors, like Cypriots in 2012, are not allowed to just take their bank notes out of the bank permanently. The reality is that this act does not resolve the initial problem with balance sheets being overwhelmed by capital losses. Even under fiat, asset values must correspond to the value of the corresponding bonds for a bank to remain solvent. The final collapse of fiat will occur when the burden of debt exceeds the ability of any debtor, no matter how large their balance sheet, to service it. When lost capital can no longer be replaced with fresh capital from a more creditworthy institution, one can arrive at a situation where bank notes are literally backed by nothing. A bank note backed by nothing can purchase nothing. It will not matter how many are released into the economy at that point. They will be worthless. It will be the Zimbabwe solution in spades.