The inevitable collapse of the financial system

Credits: Rilsonav

Productive capital is built up by the creation of a permanent and irrepayable debt owned by the investor and owed to him in perpetuity.

— Frederick Soddy, The Role of Money, 1934

Shocking titles are usually misleading, at least partially. However, if you stay with me for a few minutes, I hope to convince you that almost complete loss of confidence in currencies and the resulting collapse of the financial system is the most probable course of future; in fact it may be almost inevitable.

Let’s start with a 100 people at a place making 200 pencils a year. They decide to elect a Government of 10 people to manage communal tasks leaving the rest 90 to make 180 pencils. The Government collects 20 pencils to pay itself and to, say, build roads once a year. [Roads made of pencil aren’t the best, but the people seem to prefer it to having no roads.]

Now, in order to win the next elections, the Governors start promising more roads than can be built with 20 pencils. To build these roads, the Government collects the usual 20 pencils as taxes, and gets 10 more by promising to return them later, or in other words, by issuing bonds. 20 of the 30 pencils thus ‘accrued’ are paid as salaries. The rest 10 are used to build the roads.

The bonds issued by the Government are purchased by relatively ‘better off’ people who call themselves ‘investors’. This would go on year after year leading to mounting debt. The number of available pencils after the road is built are 180–30=150. These are consumed by the people.

However, the story doesn’t end here. In fact, it is only the beginning. The government, having discovered its unlimited ‘credit-worthiness’, and therefore unlimited potential to raise debt, decides to ‘intervene’ in other ways, for the ‘greater good’.

It creates a Bank to issue currency against its debt. In other words, this Bank buys the bonds owned by the people and issues them pencilmoney. This currency then becomes the primary mode of exchange of value among the people. The Bank initially issues 10 pencilmoney to the investors against the outstanding Government bonds worth 10 pencils.

It dawns on the Government that the more pencils the people ‘consume’, the greater bliss they experience. The people also have the capacity to produce more pencils by reducing their ‘unproductive time’ and through ‘technological progress’. On the other hand, some ‘visionary entrepreneurs’ complain that the ‘startup ecosystem’ isn’t ‘taking off’ due to unavailability of ‘funding’.

Therefore, for ‘growth’ and ‘development’ of the society, the Bank issues 50 new pencilmoney as ‘reduced rate loan’ to the entrepreneurs, guaranteed by the investors. The Government also does its bit to contribute to the ‘growth story’ by providing subsidies. The subsidies are funded by ‘job creation’ bonds worth 5 pencilmoney bought by the Bank. The outstanding currency is 10+50+5=65 pencilmoney.

The entrepreneurs try to act on their ‘vision’ and ‘courage’. However, they face another difficulty. They need people to rapidly learn their ‘disruptive’ methods, but the people seem to take too much time and pencilmoney to do it. They complain about the ‘unemployability’ of people. The people, enamored by the prospect of a blissful pencilmoney salary, put pressure on the Government to ‘invest in education’. The Government decides to ‘invest in future’ by creating Pencil Institute of Technology (PIT) which churns out new well-trained ‘engineers’ and ‘professionals’. It funds these programs with ‘no child left behind’ bonds worth 10 pencilmoney bought by the Bank. The outstanding currency is 65+10=75 pencilmoney.

The entreprenuers are also worried about the safety and security of their facilities and produce. They complain that the lack of ‘law and order’ is affecting the ‘investment climate’. The Government, consumed with guilt, creates Pencil PD funded with ‘sanctity of life’ bonds worth 10 pencilmoney bought by the Bank. The outstanding currency is 75+10=85 pencilmoney.

With rising ‘ease of doing business’, the ‘trailblazers’ employ ‘innovative’ and ‘revolutionary’ means of production to create 100 pencils, ‘ushering in a new era’ of pencil abundance. The 55 pencilmoney taken as loan and subsidies is given to the employees. The 20 pencilmoney for the Pencil PD and the PIT also end up with the employed people. All the employees then buy and consume 50 pencils, feeling greatly blissful in the process, having been able to consume more pencils than the ‘masses’. They start calling themselves the ‘middle class’, to underline their blissfulness as compared to the ‘bottom of the pyramid’. The Government collects 10 pencilmoney as Goods Tax and 10 pencilmoney as Corporate Tax. The outstanding inventory is 100–50=50 pencils. The companies have 30 pencilmoney, the Government has 20, the investors have 10, and the people have 25.

The investors, who have guaranteed the corporate loans from the Bank, complain about lack of ‘exit options’. The Government, in order to improve investor prospects, creates a stock market in which companies could ‘share their upside with retail investors’. The middle class, using savings from the unconsumed part of their salaries, and with deep knowledge of how ‘equity always outperforms all other asset classes in the long term’, rushes to buy shares in the companies and become part of the ‘growth story’ leading to start of a ‘bull market’. Some of the purchased shares provide a partial exit route to the investors, while others are freshly issued to fund the growth plans of the company. The people ‘invest’ 10 pencilmoney in the companies, buy shares worth 10 pencilmoney from the investors, and are left with 5 pencilmoney as savings. The investors and the companies are now ‘flush with cash’, while the investors and the middle class are ‘flush’ with shares.

However, the demand for pencils remains ‘subdued’. To ‘spur growth’, the Bank offers pencilmoney at lower interest rates. People take loans worth 10 pencilmoney buying 10 pencils. Even though this does increase the demand slightly, people don’t seem to rapidly catch up to the Government’s mantra of ऋणं कृत्वा घृतं पिवेत (a Sanskrit proverb meaning ‘Take loan and drink clarified butter [enjoy]’). The outstanding currency now is 85+10=95 pencilmoney. The pencil inventory is 50–10=40.

To further ‘stimulate demand’, the Government starts providing ‘incentives’ for people to buy pencils. The incentive drives a further sale of 10 pencils, with 5 pencilmoney in Government incentives funded from its reserves, and the additonal 5 pencilmoney coming from the remaining savings of the people. The inventory now is 40–10=30 pencils. Of the 95 outstanding pencilmoney, 15 is with the Government, and the rest 80 is with the investors and companies.

The recent sales drive the share prices, and the ‘market capitalization’ of the companies shoots up, leading to their increased ‘credit-worthiness’ and a further rise in the share prices. The companies carry out a series of ‘mergers and acquisitions’ in search of ‘efficiency’ and ‘synergy’, and ‘announce plans’ of improvements in technology and ‘supply chain’, increasing the share prices even further.

However, the ‘consumer sentiment’ continues to be ‘lukewarm’. Foolish ‘masses’ don’t seem to be hyper-driven by the cosmetic ‘incentives’ of the Government. Even though loans at extremely low interest rates are made available by the Bank, the bliss of debt-fueled pencil consumption seems to elude the ‘middle class’.

The Government and the Bank are both desperate to bring bliss to the ‘grassroots’. Rock bottom interest rate loans from the Bank and cosmetic incentives from the Government having failed to cause a major ‘spurt’ in demand, its time for more ‘aggressive measures’. The two decide on a ‘two pronged strategy’ to ‘drive consumption’.

The Bank, which was erstwhile buying only Government bonds and issuing pencilmoney against it, now starts buying private debt from individuals and groups of individuals, and issuing currency against it, calling it as ‘Quantitative Easing (QE)’. The Bank buys a total of 15 pencilmoney worth of private debt. The erstwhile creditors among the people, excited with new pencilmoney received from the Bank, buy 15 pencils and consume them. The share prices reach ‘new highs’. The outstanding currency now is 95+15=110 pencilmoney and the inventory is 30–15=15 pencils.

While the overall corporate sector has excess cash, some of the companies are struggling due to various reasons. They book losses and are unable to ‘service’ their loans. They plan to ‘significantly downsize’ or even ‘shut shop’. Worried by the prospect of loss of ‘jobs’, the Government decides to ‘bailout’ these businesses. It recapitalizes the struggling companies with 15 pencilmoney from its reserves, and gets a ‘stake’ in them in return. The ‘economy’ is ‘rescued’ from the impending crisis. ‘Everyone’ praises the timely and important intervention of the Government.

However, the ‘experts’ are ‘worried’. They warn of ‘headwinds’ in the next year due to inventory unsold this year. There is also another group which is gaining political and numerical strength. They call attention to the fact that the standard of living of majority of the population remains ‘bare minimum’. They declare that it is the moral responsiblity of the Government to ensure a minimum standard of living. They get support from the ‘experts’ who announce that it has ‘emerged’ that the Government can borrow much more than ‘previously thought’, elucidating the ‘Modern Monetary Theory (MMT)’.

The Government decides to ‘bring a stimulus package’. It sells ‘war on poverty’ bonds worth 15 pencilmoney to the Bank and distributes the cash among the ‘have-nots’, leading to the remaining 15 pencils getting sold. The Government rises in popularity owing to its ‘welfare program’. The companies’ performance ‘exceeds all expectations’ and the share market ‘breaks all records’. The ‘economy’ is ‘growing like never before’ and the ‘experts’ say that the ‘peak’ of the ‘bull market’ is ‘yet to come’.

The outstanding cash is 110+15=125 pencilmoney, all of it with the companies and investors. In other words, the Bank owes 125 pencils to the companies and investors. 25 pencils are owed to the Bank by the people (10 taken as loans from the Bank + 15 private debt purchased by the Bank during QE), 50 by the companies (taken as loans from the Bank), and the rest 50 by the Government.

The ‘experts’ predict ‘unprecedented growth’ in the ‘years to come’, ‘driven’ by a ‘robust economy’ and a ‘healthy’ debt-to-GDP ratio of 125/280=45%. The government owns shares worth 45 pencilmoney (purchased with 15 pencilmoney during ‘recapitalization’) and the people own shares worth 60 pencilmoney (purchased with 20 pencilmoney). The investors own much more shares. The Government declares a ‘fiscal deficit’ of only 50–45=5 pencilmoney and the middle class nourishes dreams of becoming investors when their shares grow ‘10x’ and become ‘multibaggers’.

Epilogue

I have failed in my communication if I have not been able to create a sense of something-not-adding-up in the above story. However, I know my limitations, and therefore, I will attempt to elaborate on my major points. They are as follows:

1. Majority of the debt is owned by the entities who are already over-stretched: the people and the Government. This debt would increase every year. There doesn’t seem to be any arrangement, at least in the near future, by which this debt could reduce.
2. The ‘economic growth’ is primarily fueled by the capacity of the people and the Government to get indebted.
3. This is not to say that all economic growth is exploitation. After all, roads were built, institutes functioned, police operated. The standard of living of the people also improved. However, the primary enabler of this was the promise to pay back in the future, the prospect of which would seem almost non-existent to most realists.
4. The ‘assets’ of the Government and the people are in the form of shares, which are again a form of borrowing from the future. The shares would only hold their value if the consumption increases in the future (as ‘predicted’) which would in turn only be possible with ever greater debt. [The assets were considered as shares in the story only for simplicity. The fact that the value of assets is a form of borrowing from the future applies to all assets which cannot be directly consumed.]
5. Only prudent and efficient interventions by the Government and the Bank were considered in the above story. For example, the Government gave subsidies of only 5 pencilmoney to the companies and reaped 20 pencilmoney as taxes. The QE program of the Bank also assumed that all the private loans will be repaid, never becoming ‘non-performing assets’. In reality, all the interventions of the Government and the Bank are full of leakages and inefficiencies.
6. The fundamental point is this: the standard of living of the population can be improved, but only by promising future returns to the people controlling the ‘means of production’, in other words, by becoming indebted to the people controlling the means of production. Since neither the indebted population, nor the Government produces in excess, honoring the debt doesn’t seem to be happening anytime soon.
7. As long as pencilmoney is tied to pencils, there does exist a remote possiblity of a miracle invention of a magic pencil machine in the future which settles all the debt of the Government and the public. However, the fact that the currencies in the real world have a floating, ‘market-determined’ value, settlement of the debt becomes almost impossible. This is because, with market-valued pencilmoney, even if the aforesaid magic pencil machine was invented, the pencils themselves would lose value and would not be able to buy enough pencilmoney. In other words, if such a machine were to be invented, the creditors would refuse to accept pencils to settle their debt and would demand other items that still retain their value.
8. Said differently, market-valued currency implies that the debt is promised to be settled in the form, medium, and at the time chosen by the creditors. Remember that the creditors want only a negligible portion of the debt for their own consumption. They want to be able to sell almost all of it.
9. Anything that the people will learn to produce in abundance cannot be sold by the creditors. Therefore, they will refuse to accept it. This implies that the Government and the people will forever be increasingly indebted to the creditors; increasingly, because the creditors would continue to control the means of production and the Government and the people would need the produced good and services to maintain/improve their standard of living.
10. What is the form of this debt? It is just a written assurance, in the form of currency, that the debt will be paid back. No assurance can hold its value with ever-decreasing prospect of acting upon it. This would eventually lead to a collapse in confidence in the currencies, wiping out of assets of investors and companies, and resulting collapse of means of production.

Conclusion

1. Economic value is produced by consumers fulfilling their needs and desires in exchange for promise to pay back the value in the form, and at the time desired by the producer.
2. The system is balanced if the consumers produce of equal value (the producers consume of equal value). Otherwise, it creates debt: the promise of paying back in the future.
3. As long as everyone doesn’t produce the value they consume, there exist some producers who produce in excess of what they consume. In other words, if the producers produce more than they consume, they get others to consume their excess produce in exchange for promise of future pay back (currency in other words).
4. No mechanism exists for this future pay back. Even a possible future abundance would not allow this pay back since the abundant goods and services would lose their value. In other words, the abundant goods and services would not be accepted by the cash-rich producers since they need the goods and services for re-selling (and only a neglible portion for their own consumption).
5. Thus, the fundamental basis of all currency (and thus most of the wealth) is unrepayable debt: either owed by the Government or the net consumers to the net producers.
6. This is unsustainable and its eventual collapse is inevitable.

“If something cannot go on forever, it will stop.”

— Herbert Stein, Wall Street Journal, May 1985