Guest Post: How the Paper Money Experiment Will End

Tyler Durden's picture

Submitted by Philipp Bagus via the Ludwig von Mises Institute,

A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this scenario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.

This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.

We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.

So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?

There are at least seven possibilities:

1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.

2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.

3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.

4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.

5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.

6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.

7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.

Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.

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docmac324's picture

Or, just keep kicking the can, forever.

IndicaTive's picture

There's always Bitcoin.


hedgeless_horseman's picture



The Twelve Steps

  1. We came to understand that our government is powerless over its spending - that our nation's debt had become unmanageable.
  2. We came to believe that a power greater than our fiat currency could restore us to sanity.
  3. We made a decision to turn our savings and our investments over to
    the care of gold, as we understand gold to be a physical asset - not a
    paper promise.
  4. We made a searching and fearless inventory of our wealth.
  5. We converted to gold, to Krugerrands, and to Maple Leafs, the fiat
    paper assets of our wealth, thus eliminating our counterparties.
  6. We were entirely ready to have gold remove all risk of default.
  7. We humbly asked the coin dealer to reduce our exposure to The Inflation Tax.
  8. We made a list of those politicians that expose us to The Inflation Tax, and became willing to work against them all.
  9. We gave direct support to Libertarians whenever possible, except
    when no Libertarian is on the ballot, and then we voted against the
  10. We continued to create wealth through our own industry, and then we converted it to gold, and promptly buried it.
  11. We sought through silver coins to increase our contact with precious
    metal, as we understand silver to be a physical asset - not a paper
    promise, paying for as many day-to-day transactions with silver as
    possible, using our credit card (not debit) for what was not, and paying
    off the entire balance each month.
  12. We, having had a fiscal awakening as the result of these steps,
    tried to carry this message to others, and to practice these principles
    in all our affairs.

Kirk2NCC1701's picture

In your original post of 1/8/12, someone commented that the billionaire Koch Bros co-opted the Libertarian movement.  Is this (still) the case?  If so, "toward what end" is a fair Q. 

My guess is that, aside for their own (financial) benefit of lower taxes and less IRS inquiry, that the official (big-"L") Libertarian movement becomes part of the "Controlled Opposition".  No?

JailBank's picture

Yeah I am sure that with the current tyrant in chief running the show the Kochs are not getting any treatment from the IRS. Are you kidding me?

zaphod's picture

You forgot:

8 - Tyrannical Leader. The People and organizations who's livelihood depend on the government, comprise a majority who vote for a US leader similar to Chavez, Stalin or Hitler. Government eliminates all remaining opposition who at that point are deemed lawless criminals.

IMHO #8 is more likely than anything else.

layman_please's picture

and somehow they always find an excuse to start a war (no 9).

fonestar's picture

The problem isn't that these systems are paper (they're digital not paper anyway).  The problem is that they are run by humans.

the grateful unemployed's picture

if only there were run by humans we could something about it

MisterMousePotato's picture

I once read a compelling, arguably dispositive, argument about how fractional reserve banking is a good thing. The example used to illustrate the point the author was making was an individual who brings $100,000 to another planet and deposits it in a bank there. (One without any other depositors, FWIW.)

Been a while, but I remain convinced that the problem is not 'the system' per se, but rather that greedy and incompetent sociopaths always fuck it up for their own private profit at the expense of everyone else.

Stuck on Zero's picture

Has anyone ever seen an honest government create inflation?


sixsigma cygnusatratus's picture

"We made a list of those politicians that expose us to The Inflation Tax, and became willing to work against them all."

When the red and blue team workers come by during election season, I usually tell them " I don't vote anymore.  It just encourages them."  You should see the looks I get.  Priceless!

Gold Eyed Cat's picture

<--  drop 20k on the house and get the balance under 25

<--  wait a few months and buy 20k in PMs when the price is sweet


I know, I know.  Posing hypothetical questions, and asking for opinions on a message board are both signs of stupidity!  I just can't resist.   

falak pema's picture

Dictatus Papae had 27 steps, Hitchock's film had 39 and Herman G Kahn's diatribe on cold war had are a TRUE economist!  

Its not the number of steps, like Martin Luther and his 95 edits, its a question of mission statement : What is the agenda, is it MEans or an END? 

The libertarian creed is a leopard which wants to change its SPOTS!

Not its true creed. TRy chewing on that. What is libertarianism in the US political tradition?

Is it evangelical? Is it anarchist? Is it small government and modest...If so, how does it prevent a nation becoming a Genoa, small  city state, in times of invading Empires obliged to SELL its soul in great game plays of others? 

The true historical thread, the fight between top down History and bottom up Counter History is a bitch! 

wee-weed up's picture



Any of the seven options, or combinations of two or more options, may lie ahead.

Are you kidding me... How about ALL of the above!

Honey Badger's picture

"Pay off the debt"

ha ha, ho, ho, ha ha, LMFAO!!

MisterMousePotato's picture

Good point. I hit him with a happy uptwinkle before giving it the thought you did.

michael_engineer's picture

No mention of the Executive Order combining with any of them either.

just-my-opinion's picture

I love that comment

I gotta big free-way and a big can

Did I tell you...I was a soccer player

JailBank's picture

I am very afraid of the default of entitlements. Can you imagine what would happen when the ghettos, barrios, and trailer parks start to empty? The folks are going to go looking for a scapegoat. I only hope they by pass my middle class neighborhood and head straight to for the rich folks.

CrimsonAvenger's picture

Yeah, we joke a lot here, but there is some serious shit about to come down. I'm afraid as well.

JailBank's picture

I tell the wife all the time, when the freebies get cut off people collecting them are not just going to sit back and take it. They are going to get out of the house and go take what they want. The cops won't be there to stop the mob, becuase they will be at home protecting their families.

css1971's picture

You should think of police as janitors. They exist as a profession to clean up after a mess.

Uber Vandal's picture

Ever think you might be "rich folks" to people with less than you have?

Ever think that the layout of some cities is not by accident but design for when such a day comes, and your neighborhood may be a buffer zone?




JailBank's picture

I have thought about that, and that is why I have a plan to get the hell out and the supplies to do it. I live less than 2 miles from the end of the city limits on the south side of my city. The rich live in the middle and out west.

JailBank's picture

The poorer folks live in up north and and east.

Calmyourself's picture

I would keep this in mind.  If your bug out includes driving through the spread out neighborhoods on 5-10 acre lots 15-30 miles outside of city limits they may actively funnel you right back to the interstates.  Sometime disasters cause lots of physical mayhem that might block roads.  Bug out plans that include all those back roads like the "experts" advise may not be that convenient when the time comes...  Now you know.

El Vaquero's picture

I have a jeep and know the rickety little dirt roads very, very well.  If I need to get the fuck outta dodge, I'm not going to take the routes that everybody else does.  I figure 10mph on dirt is better than stopped in a miles long traffic jam. 

Moe Hamhead's picture

It's all going to burn !

howenlink's picture

I think more accurately it is the "fiat money" system that has failed.  Don't let them trick you into accepting digital fiat.

oddjob's picture

Convenience junkies will lap that shit up.

hedgeless_horseman's picture



How would youlike to pay for your iPad?  We accept iDebit, iCredit, iCard, and iMoney.  If you wish, we can provide you with an instant iLoan, because we already know your iScore.

oddjob's picture

I'm going to hold out getting any icrap until they pay me to use it.

Kirk2NCC1701's picture

Philipp Bagus, are you one of the Baguses of the Shire?  You must know Frodo.  ;-)

Fed Gollum:  We hates the Baguses!  We hates them!  Their sword of Truth... it burns us!

Stackers's picture

Solution #1 is only choice they have

Solution #2 through #7 are all HUGELY deflationary and collapse the money supply which equals death to a fractional reserve debt/credit/money system

NotApplicable's picture

While the only challenge is to "manage expectations" in order to stave off the loss of confidence known as hyperinflation.

dbTX's picture

We pring so we can buy plastic trinkets for China, so they can lend the paper back to us so we can pay them interest on the paper junk. What a great plan, nuke the fed!

dizzyfingers's picture

Behead the bankers, along with the lawyers... Where are those guillotines?

Pseudo Anonym's picture

the guillotines are behind the 2 billion hollow point bullets the bankers bought recently to keep you away from the guillotines

Grande Tetons's picture

It should end something like this,

After that we can all relax and have some nice grilled chicken. 

rosiescenario's picture

If one looks at the current value of $1 and at its value 40 years ago, it is pretty clear that inflation is the MO.....why would this possibly change?

apberusdisvet's picture

And the end of the planet end game that is the uncontrollable radiation from Fukushima fits where in all these scenarios?

TwoCats's picture

That ends with me going long lead futures.

Come to think of it, lead is a good choice either way.

Lost Word's picture

EPA recently shut down the only lead ore smelter in the US.

Soon only the Government will be allowed to own bullets.

docmac324's picture

I can start to explain what would happen if my military retirement checks stopped (22 yrs).  A few buddies and myself may start a ruckus.

nobodyimportant's picture

Anyone who served in the banker wars for 22 years without wising up does not deserve a pension,

IcarusOnFire's picture

Hey Doc wake up.  It's already started.  The CAmel's nose is in the tent.

As part of the budget deal agreed upon yesterday projected Military Retirement paychecks will be cut by 1% a year.  The deal falls apart without this savings.  Let's see how many start a ruckus?

This one percent cut EVERY YEAR to COLA applies to all retirees under the age of 62.  That's a 20% cut to the average retiree paycheck when you hit social security retirement age.  Next step, to reduce benefits if you are double dipping and receiving social security.

"First they came for the Communists, I did nothing because I wasn't a communist.

They came for the trade unionists, and I did nothing because I wasn't a trade unionist.

They came for the gypsies, and I did nothing because I wasn't a gypsy.

They came for the catholics and I did nothing because I wasn't a Catholic.

Then they came for me, and there was no one left to fight for me."

Martin Niemoller