Monday, May 18, 2009

Musings on Debt as Money

In the United States, all of our money is government debt (Federal Reserve Notes). Without government debt, we would have no money, the entire system is dependent upon debt and the creation of more debt to increase the money supply. Anytime the FED wants to increase the amount of Federal Reserve Notes outstanding, it purchases US Govt. Bonds. Under a situation where the government runs a surplus and reduces the national debt to a point where it doesn't need to issue bonds (Greenspan talked about this during the late 90's) the FED's ability to increase money supply would be severely hampered. It could purchase private bonds, but that too is debt.

Now that I think of it, this sort of makes sense. What are save, we are shifting consumption to the future. Our ability to consume more in the future must be met by someone else's obligation to forgo their future consumption. That obligation can be called debt. So money is a form of savings, it makes sense for that savings to be in the form of someone else's debt.

The current global monetary system is a very new invention. It was created only during the 1970's! Before then, we had the Breton Woods system whereby the dollar was linked to gold and everyone else linked to the dollar. So it was still a gold based system, though a weakly linked one.

Is this system sustainable? There seems to be a free lunch inherent in this system. In theory, money supply has to increase as the GDP increases (output). Government can get a free lunch by creating debt, which is money they can use, and that debt never has to be paid back because it is circulated as money.

Now since the dollar is the world's reserve currency and therefore is essentially the money of the world, the United States can get a free lunch by creating debt, monetizing it, and then exporting it overseas to fill the world's need for more money as world output expands. That debt never has to be paid back, those dollars, which is our debt, circulates as money. As long as the world continues to expand output, they will need more and more money, allowing us to create more and more debt which circulates as global money.

Would this system collapse if the dollar were no longer treated as global money?