Friday, January 23, 2009

Review of fiat currency systems and national debt.

The below remarks by Mr. Schiff beg the question of whether or not the premises he relies on to formulate predictions are correct. Being right for the wrong reasons (thus destroying any chance of future generality) is a terrifying prospect for policy makers and economic theorists.

And so today I respond to this notion that foreign nations "fund" American national debt (or the corollary "what if no-one buys our debt??) in an era of floating, fiat currency.

I am not advocating a monetary system here, only recounting what I see as true. The government has sole control over our monetary system. This does indeed make me somewhat nervous given the history of same. I am also not discussing geo-political concerns, which are of paramount importance in my opinion on all economic matters...this is only a little discussion on monetary economics.

First off, its been a brave new world since 1971. The gold standard set limits to bank reserve multiplication and money supply. This is no longer the case with the current "modern" system.

The U.S. does not need to borrow, tax, or do anything of the kind in order to spend. That statement itself throws people off when I try to explain current monetary economics. The U.S. dollar is a currency of the Federal government's creation. It spends in that currency. It does not have to "get" dollars from anywhere or anyone in order to spend them.

But what happens when government issues Treasuries?. It simply offers banks and foreign countries an opportunity to exchange cash (and non-interest earning reserves) for interest-earning Treasuries. It inures to our benefit if countries do not wish to earn interest on their reserve assets. The Fed spends, adds reserves to the banking system, then "borrows" if it wishes to drain the reserves.

So our (wonderful and benevolent) Federal Government spends (literally creating money by crediting bank accounts), then taxes and we are left with the remainder.

Thus, if China, Japan, OPEC members, et al., decided no to buy our debt, what would really happen? Recall that Real goods and services are leaving said countries. We have been getting those real goods and services, and providing the world's only reserve currency. In order for the trade surplus to balance, we tacitly agree to later export our goods and services at whatever prices we wish. We have benefits and they have costs, promises, and the peace of mind that comes with holding 2 Trillion dollars in U.S. securities that only decrease in "value" when panicked holders sell them.

In other words, they are in an epic Gordian knot. If we did not design this knot, then we should have because it near-guarantees the continued reliance on the dollar and the international security that only the U.S. can provide. This is the greatest non-military victory in the history of the world. One wonders if Nixon realized the power he granted to the U.S. when leaving the Gold standard. It also has the added benefit of (hopefully)ensuring relative peace during harsh economic circumstance.

Of course, with our military being 20 times as effective as the next 8 countries combined...

The World Won't Buy Unlimited US Debt
2009-01-23 02:27:40.359 GMT

By Peter Schiff

Barack Obama has spoken often of sacrifice. And as recently as a week ago, he
said that to stave off the deepening recession Americans should be prepared to
face "trillion dollar deficits for years to come."

But apart from a stirring call for volunteerism in his inaugural address, the
only specific sacrifices the president has outlined thus far include lower
taxes, millions of federally funded jobs, expanded corporate bailouts, and
direct stimulus checks to consumers. Could this be described as sacrificial?

What he might have said was that the nations funding the majority of
America's public debt -- most notably the Chinese, Japanese and the Saudis --
need to be prepared to sacrifice.
They have to fund America's annual trillion-dollar deficits for the
foreseeable future.

These creditor nations, who already own trillions of dollars of U.S.
government debt, are the only
entities capable of underwriting the spending that Mr. Obama envisions and that
U.S. citizens demand.

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