A lecture on money until the curtain rises again

As I stated in a previous column, I had no doubt that the debt ceiling would be raised and that an agreement would be reached to fund the federal government, at least on an interim basis. The debt ceiling drama is currently in intermission. The curtain has temporarily been brought down on this political theater.

It has become a long-running series: the debt ceiling was raised for the 28th time since 1978. In this most recent episode, the mainstream media has cast the Republicans in the role of the villain. Let’s watch for possible Emmy nominations.

Inexplicably, the Democrats have been cast as the good guys, heroic politicians that succeeded in raising the debt ceiling, rescuing us from a fate worse than death while plunging us deeper into debt. This is clearly a case of role reversal. In 2004, every single solitary Democrat in the House voted against raising the debt limit. Similarly, in 2006 every Democrat in the Senate voted against raising the debt limit, including then Sen. Barack Obama. Were the Republicans the good guys back then? There appears to be no moral to the story, only partisan politics. Neither party has a consistent record of supporting fiscal responsibility. They appear to be trading off reading lines from a bad script.

There is a reason for this. The dysfunction we see in Congress is a symptom. The underlying root cause of the problem is that there is a fundamental flaw in our monetary system. According to Aristotle, money is a means to an end, not the end itself. Most people, including most members of Congress, do not understand the nature of money or the importance of how it comes into being.

Every U.S. dollar that enters into circulation is a debt obligation. In overly simplified terms, here’s how it works. When the Treasury borrows money, it issues Treasury bonds (that’s the root of the word “bondage”). These bonds are purchased by primary dealers, mostly comprised of the “too big to fail” banks. These dealers then re-sell the bonds at a profit. These days, they sell almost all of them to the Federal Reserve because there are fewer other buyers now than in the past. The Fed pays for the bonds by issuing the equivalent of a check written on an account that has a zero balance. Please read that last sentence over and over until it sinks in. In this way new dollars are created. What would happen, dear reader, if you issued a check from an account that had nothing in it? The process is similar throughout the banking system, except that commercial banks are required to keep funds in house as reserves.

The newly created dollars represent only the principal portion of the loan. The dollars needed to pay the interest on the loans never enter the system except through additional borrowing, which then requires even more interest to be paid, which then requires further debt expansion. If you’re saying to yourself that this sounds like a pyramid scheme, I wouldn’t argue with you. In this system you cannot have economic growth without debt expansion. That is a fatal flaw in and of itself. Add to that, the catch-22 that there is not enough money in the system to pay off the principal plus the interest let alone account for nonperforming loans. At some point there is a bust or recession. Or worse.

It is mathematically impossible for all of the debt to be paid, but if we did, we would literally extinguish the currency. It would all disappear. In order to simply maintain the status quo, our monetary system depends upon constant inflation and debt expansion. Under these circumstances, the notion of a “free market” is a fairy tale.

Debt expansion cannot go on forever; gravity eventually takes hold. The farther we go along the current path, the worse the contraction will be. James Grant, the founder and publisher of the highly respected Interest Rate Observer believes that default is inevitable. While this sounds unthinkable, the U.S. has actually defaulted before — twice during the last century with regard to dollar-gold exchange rates.

Fortunately, there are a few brave souls in Congress who are questioning our monetary system and there is a faction within the Republican Party that appears to “get it.” They are, of course, getting hammered from all sides, including their own party establishment. I believe that history will show that the critics have this one wrong. In the meantime, the curtain goes up again in January.

— Elliot Simon writes from Harpers Ferry

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