The mechanisms of monetary devaluation and the role of central money issuance

The consideration of modern economic systems reveals deep connections between government debt, the issuance of means of payment and the purchasing power of citizens. When governments finance their spending by creating new money, this has far-reaching consequences for the prosperity of the population. The historical and theoretical foundations of these processes show how quickly theTrust in a currency can dwindle.

The illusion of capacity limits and the flight to tangible assets

Economic debates often suggest that monetary devaluation only begins when the real economy reaches its maximum production potential. Only when this limit is exceeded by additional debt would there be rising prices for everyday goods. However, this assumption is fundamentally wrong and misunderstands theFunctioning of financial markets.

Market participants’ response to dwindling confidence

The capital market forms its own cosmos, in which there are many other stores of value than the predominant legal tender. As soon as the first participants notice that the circulating money is faced with less real values than the nominal amount, they switch to alternative assets. You don’t have to wait for the prices of everyday goodsvisibly increase, but focus on the balance sheets of the money issuers.

Escape into foreign currencies and tangible assets

Market participants also do not wait until they want to buy real goods and then run into bottlenecks. Instead, they immediately bring their wealth to safety as soon as the equity of the central institution disappears or threatens to disappear. This evasion takes place by acquiring corresponding values against the money losing its exchange value.

The grip on foreign exchange, precious metals and company shares

Savers use foreign currencies to protect their assets. Likewise, they take refuge in real values such as company shares or land ownership. Alternative stores of value such as precious metals or digital units also experience massive inflows in such phases.

Premature devaluation due to rising asset prices

While inflation on the goods market may actually be delayed, a currency decline manifests itself much faster in a price decline compared to the other values mentioned. In other words, this is reflected in a massive price increase of these alternative investments. With this development, one therefore notices the creeping decline of the currency at an early stage.

The fallacy of simple debt cancellation

Another naive idea is that you can simply cancel debts that the central bank has bought up. Many mistakenly believe that these liabilities were financed with money created out of thin air. Again, this assumption is wrong, and economic logic requires a deeper understanding.

The need for real value relinquishment

Reason dictates that there must be someone who renounces real values when debts are forgiven. Debt always stands for the fact that someone has made advance payments and has waived real goods. It is not a question of whether these people exist, but only who exactly they are.

The expropriation of creditors through state intervention

Because someone has to face these debts and believe that they are entitled to payment of the claims. If the debts are cancelled, this creditor is forcibly expropriated. So who will be expropriated if loans or government debt that are on the balance sheet of the central institution are cancelled?

Access to the issuer’s equity

In terms of accounting, the asset side is shortened, because the national debt is a claim of the central institution on the tax authorities. We know what these assets face, namely the institution’s equity and the circulating money on the liabilities side. If the national debt is cancelled, this is initially at the expense of equity.

The Confiscation of Security Reserves

The state confiscates the equity of the central institution in this way. This capital is actually intended to ensure the recoverability of the circulating money. As long as equity is still available, assets may fluctuate without any particular impact on purchasing power.

The creeping devaluation of cash

Here, equity acts as a buffer for possible losses. As soon as the equity is used up, any further reduction in the assets is at the expense of the circulating money. This way we know who pays the cancelled debts, namely all those who are nominal money holders.

The tacit expropriation of citizens

These affected persons include employees, civil servants and pensioners who are entitled to fixed flows of money. Their money is devalued and they are partially expropriated without realizing the cause. This is first reflected in the external value of money vis-à-vis foreign currencies and other stores of value.

The historical lessons of the great monetary devaluation

Later, the loss of purchasing power is reflected in rising prices for everyday goods. Historical examples show how quickly such mechanisms work. At that time, the currency had plummeted further until unimaginable sums had to be paid for a single foreign currency unit.

The return to coverage by real values

However, from a certain day in November, the exchange rate leveled off at a fixed exchange rate and stopped there. The decisive reason for this was that another step was taken on the same day. The central institution stopped the banknote press and no longer discounted government treasury bills.

The cessation of direct government funding

So she no longer took on government debt on her books to spend the corresponding amount in return. Now new money could only be spent if trade bills were deposited in exchange for it. So the money had to be backed by a real value, as it had been before the war.

Immediate stabilisation through harsh rules

Only a few days after this step, the further decline of the currency had stopped. The question remains as to why a central institution is needed at all when the impairment test is carried out by the private banks. Only these are incentivised to carry out the audit correctly and to assess risks.

The pro-cyclical nature of commercial banks

There are several main reasons for this, because commercial banks tend to behave in a way that destabilizes the overall market. In boom phases, they grant loans simply because they expect regular repayment. In addition, the prices of assets rise in such times, so that supposedly good collateral is available.

Strengthening upswing and downswing

Loose lending is actually growing the economy, attracting and financing more and more investment projects. The possibility of cheap money is creating a huge upswing. However, this attracts increasingly unprofitable businesses, which are only kept alive by the large amount of money.

The risk of a liquidity squeeze

As soon as the expansive phase ends, banks become more restrictive in lending and assess collateral more pessimistically. This now exacerbates the downturn, because they also make lending more difficult in economically difficult times anyway. This is reasonable from a bank-specific point of view, but not from a holistic point of view.

The fear of savers and the rush to the banks

In this way, liquidity bottlenecks can occur at individual banks, especially in a downturn, with customers reclaiming their deposits. Because a bank’s values are usually tied up in longer-term projects, this can lead to a short-term hitch. This means that although the bank is not over-indebted, it can become insolvent in the short term.

The self-reinforcing panic of the markets

The mere possibility of this condition can cause a rush of customers. Savers only withdraw their deposits because they fear that other customers might do the same. The central institution has the task of mitigating the overshoot in both directions.

The balancing role of central spending

It is intended to act as a brake during the upswing and as a stimulus during the downswing. It should also supervise the banks overall, because it has an overall view and not just the local view of an individual bank. Should a crisis nevertheless occur, the task of the institution is to step in as the lender of last resort.

The provision of emergency liquidity

It provides the liquidity necessary in the short term to prevent the self-reinforcing effect of a customer onslaught. In such a case, the institution may make use of its ability to issue money in any amount. If the motive of the non-banks in such a case is not to spend the money, but to stockpile it, thisApproach hardly increasing the price level.

The takeover of bad loans and the erosion of the balance sheet

This is also the way in which bad bank balance sheets can be highly aggregated to the central institution. Suppose a commercial bank issues a loan to a debtor with insufficient repayment capacity. Because if their equity dwindles, the bank threatens to collapse.

The Conflict Between Help and Moral Hazard

The central institution could now take over the bad loans directly or indirectly against newly created money. Actually, she doesn’t want to do that in order not to corrupt the system. On the other hand, however, it is very difficult to distinguish this case from a commercial bank that got into trouble through no fault of its own.

The incentive for short-term rescue

The central institution therefore always has an incentive to help at short notice, even if this erodes the overall system. As a result, it gradually worsens its own balance sheet. It is important to realize that a central institution does not have to be state-organized.

The private organization of the reserve system

It would also be possible for the commercial banks to combine to form a reserve system that assumes the tasks of central issuance. This is exactly what happened in the United States, and the system there was founded by the banks themselves as a private network. However, such a system plays a special role, so that calls are quickly made that tasks shouldbe taken over by the state.

The danger of state confiscation

On the one hand, this is understandable, because a central institution can decide on the continued existence of an entire real economy. On the other hand, the control over the institution leads to misuse it for direct state financing. Such efforts are currently taking place again, disguising themselves as modern monetary theory.