After the near-collapse of the financial system in 2008, a growing number of people have come to realize that our monetary disease is terminal. It is that group to whom I address this paper. I sincerely hope that this group includes leaders in business, finance, and government.

I do not believe that my proposal herein is necessarily “realistic” (i.e. pragmatic). There are many interest groups that may oppose it for various reasons, based on their short-sighted desire to try to continue the status quo yet a while longer. Nevertheless, I feel that I must write and publish this paper. To say nothing in the face of the greatest financial calamity would go against everything I believe.

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It seems self-evident. The government can debase the currency and thereby be able to pay off its astronomical debt in cheaper dollars. But as I will explain below, things don’t work that way. In order to use the debasement of paper currencies to repay the debt more easily, governments will need to issue and use the gold bond (wherever I refer to gold, I also mean silver. For the sake of brevity and readability I will only say gold in most cases).

I give credit for the basic idea of using gold bonds to solve the debt problem to Professor Antal Fekete, as proposed in his paper: “Cut the Gordian Knot: Resurrect the Latin Monetary Union.” My paper covers different ground than Fekete’s, and my proposal is different as well. I encourage readers to read both papers.

The paper currencies will not survive too much longer. Most governments now owe as much or more than the annual GDPs of their nations (typically far more, under GAAP accounting). But the total liabilities in the system are much larger.

Even worse, in the formal and shadow banking system, derivative exposure is estimated to be more than 700 trillion dollars. Many are quick to insist that this is the “gross” exposure, and the “net” is much smaller as these positions are typically hedged. But the real exposure is close to the “gross” exposure in a crisis. While each party may be “hedged” by having a long leg and a balancing short leg, these will not “net out”. This is because in times of stress the bid (but not the offer) is withdrawn. To close the long leg of an arbitrage, one must sell on the bid (which could be zero). To close the short leg, one must buy at the offer (which will still be high). When the bid-ask spread widens that way, it will be for good reason and it does not do to be an armchair philosopher and argue that it “should not” occur. Lots of things will occur that should not occur.

For example, gold should not go into backwardation. This is another big (if not widely appreciated) piece of evidence that confidence in the ability of debtors to pay is waning. Gold and silver went into backwardation in 2008 and have been flitting in and out of backwardation since then. Backwardation develops when traders refuse to take a “risk free” profit. That is, the trade is free from all risks except the risk of default and losing one’s metal in exchange for a defaulted futures contract. See my paper for a full treatment of this topic.

The root cause of our monetary disease has its origins in the creation of the Fed and other central banks prior to World War I, and in the insane treaty signed in 1944 at Bretton Woods in which many nations agreed for their central banks to use the US dollar as if it were gold, and this paved the way for President Nixon to pound in the final nail in the coffin. He repudiated the gold obligations of the US government in 1971, thereby plunging the whole world into the regime of irredeemable paper.

The US dollar game is a check-kiting scheme. The Fed issues the dollar, which is its liability. The Fed buys the US Treasury bond, which is the asset to balance the liability. The only problem is that the bonds are payable only in the central bank’s paper scrip! Meanwhile, per Bretton Woods, the rest of the world’s central banks use the dollar as if it were gold. It is their reserve asset, and they pyramid credit in their local currencies on top of it.

It is not a bug, but a feature, that debt in this system must grow exponentially. There is no ultimate extinguisher of debt. In my paper on Inflation, I define inflation as an expansion of counterfeit credit. I define deflation as a forcible contraction of counterfeit credit, and the inevitable consequence of inflation. Well, we have had many decades of rampant expansion of counterfeit credit. Now we will have deflation, and the harder the central banks try to fight it by forcing yet more expansion of counterfeit credit, the worse the problem becomes. With leverage everywhere in the system, it would not take many defaults to wipe out every financial institution. And there will be many defaults. One default will beget another and once it really begins in earnest there will be no stopping the cascade.

Another key problem is duration mismatch. Today, every bank and financial institution borrows short to lend long, many corporations borrow short to finance long-term projects, and every government is borrowing short to fund perpetual debts. Duration mismatch can cause runs on the banks and market crashes, because when depositors demand their money, banks must desperately sell any asset they can into a market that is suddenly “no bid”. In two papers («Fractional Reserve is not the Problem» and «Falling Interest Rates And Duration Mismatch«), I cover duration mismatch in banks and corporations in more depth.

Most banks and economists have supported a policy of falling interest rates since they began to fall in 1981. But falling interest rates destroy capital, as I explain in that last paper, linked above. As the rate of interest falls, the real burden of the debt, incurred at higher rates, increases.

Related to this phenomenon is the fact that the average duration of bonds at every level has been falling for a long time (US Treasury duration began increasing post 2008, but I think this is an artifact of the Fed’s purchases in their so-called “Quantitative Easing”). Declining duration is an inevitable consequence of the need to constantly “roll” debts. Debts are never repaid, the debtor merely pays the interest and rolls the principal when due. As the duration gets shorter and shorter, the noose gets tighter and tighter. If there is to be a real payback of debt, even in nominal terms, we need to buy more time. At the US Treasury level, average duration is about 5 years. I doubt that’s long enough.

And of course the motivation for building this broken system in the first place is the desire by nearly everyone to have a welfare state, without the corresponding crippling taxation. It has been long believed by most people a central bank is just the right kind of magic to let one have this cake and eat it too, without consequences. Well, the consequences are now becoming visible. See my papers («The Laffer Curve and Austrian Economics» and «A Politically Incorrect Look at Marginal Tax») discussing what raising taxes will do, especially in the bust phase like we have now.

In reality, stripped of the fancy nomenclature and the abstraction of a monetary system, the picture is as simple as it is bleak. Normally, people produce more than they consume. They save. A frontier farmer in the 19th century, for example, would dedicate some work to clearing a new field, or building a smokehouse, or putting a wall around a pasture so he could add to his herd. But for the past several decades, people have been tricked by distorted price signals (including bond prices, i.e. interest rates) into consuming more than they produce.