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Economics In The Age Of Paper Money

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I call my website “Economics In The Age Of Paper Money” because our economy no longer works the way it used to when gold was money. The difference is not a small one. It is fundamental. Most economists, however, have not grasped the profound significance of the change in the way our economy works now. The purpose of my website is to point out those changes. We have a new kind of economic system. It responds differently to government policies than did 19th Century Capitalism. It is not bound by the same constraints. Our economy is turbo charged, but the operating manual that still guides the economics professions was written in the days of the horse and buggy. If we don’t learn how to operate our new economic system, it is very likely to crash.

Back in the olden days – before World War I – gold was money, governments balanced their budgets and trade between nations balanced. Sound money, balanced budgets and balanced trade were the core principles of economic orthodoxy and the foundation stones around which all classical economic theory was built.

Capitalism worked the way it did because gold (or more precisely a gold-based monetary system) would not allow it to work any other way. The gold standard forced governments to balance their budgets and it forced trade between countries to balance.

In the 19th Century, if a government spent more than it took in as taxes, it had to borrow money to finance that budget deficit. When gold was money, there was always a limited amount of money in the economy and governments could not create any more of it. Therefore, if a government borrowed a lot of money, there would be less money available for the private sector to borrow. That would cause interest rates to rise; and higher interest rates would cause the economy to suffer. Therefore, governments did their best to balance their books – at least during peacetime.

When gold was money, trade between nations had to balance because if one country bought more from another country than it sold to that country, it would have to pay for that trade deficit with gold. A persistent trade deficit would drain away all the deficit country’s money and impoverish it. Soon that country would not be able to buy any more imports because it lacked sufficient gold to pay for them. Therefore, in the past, nations were very concerned to ensure that they imported no more than they exported.

Operating within those binding constraints that the gold standard imposed, the Capitalist economy grew through a process of investment and capital accumulation. Businessmen would invest. Some of them would make a profit. They would save that profit – or, in other words, accumulate Capital (hence Capitalism). And they would repeat the process. Investment and capital accumulation drove the economic growth dynamic under Capitalism.

Everything changed when governments stopped backing money with gold. The transition from a gold based monetary system to a fiat (or paper) monetary system occurred in stages beginning in World War I, when all the European nations went off the gold standard, and ending in 1971, when President Nixon announced the US would no longer allow other countries to exchange the dollars they held into gold, thus destroying the Bretton Woods international monetary system.

Thereafter, money was no longer “sound”, governments no longer had to balance their budgets and trade between nations no longer had to balance. Governments could create money from thin air; and budget deficits and trade deficits could be financed with paper-money denominated debt. Credit growth began to explode. Every sector of the economy took on much more debt: the government, the households, the corporations and the financial sector. Total debt (and, therefore, total credit) in the US first topped $1 trillion in 1964. By 2007, it had expanded 50 times to $50 trillion. Consequently, the economic growth dynamic ceased to be driven by investment and saving. Instead, it came to be driven by credit creation and consumption.

That explosion of credit created very rapid economic growth in the US and around the world. However, in 2008, the private sector began to default on its debt on such a large scale that our new, credit-based economic system came very close to complete collapse. Had the government sector not intervened by increasing its debt by roughly $5 trillion since then (of which $2 trillion was financed by paper money creation), we would now be in a great depression as bad or worse than the one that occurred during the 1930s.

Many people think that if we just cut government spending on welfare or have fewer government regulations or fire some bureaucrats that after a short while we will once again be back in some kind of Capitalist nirvana. That is a fantasy. The truth is that there is no way for our 21st Century credit-based economic system to return to the gold-based monetary system of the 19th Century. It would completely break down if we tried to return to a system based on sound money, balanced government budgets and balanced trade. If our economic system, which I call Creditism, collapses after a four and a half decade long, $50 trillion expansion of credit, our civilization will not survive it.

Therefore, we must learn how to make our new economic system work. That is what Economics In The Age Of Paper Money is all about.

Here’s the link to my website:

Original publish date: August 15, 2012

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