• For most of us, fiat money is just “part of life”. Many of us have spent our entire lives using fiat money and have little experience with other forms of money. However, viewed from a historical perspective, the widespread use of fiat money represents part of a grand social and economic experiment.

• While commodity money and commodity-backed money both have a history of use dating back thousands of years, the use of fiat money as the primary medium of exchange is an anomaly of the modern age.

• Many economists might argue that the fiat money “experiment” was successfully concluded many years or even decades ago. Arguably, the fiat monetary system of the Western World has withstood many crises over the past several decades, during which time the major economies of the world have continued to grow. More impressively, inflation has remained relatively contained during this time, except for a brief period in the 1970s and early 1980s.

• The problem with this rosy assessment is that the real test of our fiat money system may be yet to come. More specifically, the view of The Money Enigma is that the real test of our fiat monetary system will probably occur at the point that monetary base expansion can no longer drive private-sector credit growth.

• Over the past few decades, the fiat monetary base has expanded at a rate far in excess of real output. Basic monetary theory would suggest that this should have led to high levels of inflation. But this hasn’t occurred. Why is this case? Well, in simple terms, inflation is a “confidence game”. More specifically, the value of fiat money is primarily determined by confidence in the long-term economic prospects of society.

• So far, monetary base expansion by the central banks has driven a “virtuous cycle”. Low interest rates, banking bailouts and deposit guarantees have all encouraged private-sector credit growth and this growth in credit has fueled economic growth. Strong economic growth boosts confidence in the long-term economic prospects of society, thereby putting a floor under the value of fiat money and, in effect, putting a lid on prices as measured in fiat money terms. The end result is an environment of stable prices that justifies further monetary base expansion!

• The key question that we should be asking is what happens if this virtuous cycle breaks down? For example, what happens if our economy reaches the point of “credit saturation”, i.e. the point where monetary policy can no longer stimulate credit growth?

• At this point, the “virtuous cycle” may become a “vicious cycle”. If economic growth fails to respond to expansionary monetary policy, then people may begin to question the structural health of the economy and the markets may begin to lose faith in the long-term economic prospects of our society.

• If this occurs, then the value of the fiat money that we use every day could suddenly be eroded, leading to a sharp rise in prices. Once prices begin to rise, central bankers may be forced to tighten monetary policy, leading to further declines in credit, economic activity and long-term economic confidence, further damaging the value of fiat money. The vicious cycle, once started, may be one that is hard to stop.

The Virtuous Cycle of Monetary Expansion, Credit Growth and Confidence

Many economic historians might argue that the late 20^th century and early 21^st century represent a period of unparalleled global economic growth and prosperity. During that time, most developed and developing economies experienced a period of robust economic growth and relatively low levels of inflation.

In many ways, it seems that we finally got the “secret sauce” right. Policy makers finally figured out how to manage the tools at their disposal to create and sustain the “goldilocks scenario”.

Indeed, if it wasn’t for the 2008 financial crisis and the lingering effects of that crisis, I suspect that many in our society would believe that economists and central bankers finally have it all figured out.

But have economists really been able to create a new paradigm? Have central bankers been able to perfect the fiat monetary system that we use today? Or have we all just been really lucky… at least, so far?

Let’s consider the alternative proposition: rather than becoming the masters of fiat money, the fiat money regime has become the master of our central bankers.

In essence, central bankers have become trapped in a “virtuous cycle”: a cycle of monetary expansion and economic growth that requires continued and ever greater levels of monetary expansion in order to sustain itself.

How does the virtuous cycle work? Well, let’s think about the events of the past few decades and how they have impacted our expectations.

The view of The Money Enigma is that a significant part of the world’s economic success over recent years can be attributed to an extraordinary expansion in the level of global private-sector credit. This growth in private credit has been enabled by the expansionary monetary-policy bias of the major central banks.

The growth in private-sector credit has, not surprisingly, fueled both consumer spending and corporate investment and has underwritten the growth of the global economy over the past 20-30 years.

This extended period of economic prosperity has had an important impact on our expectations for the long-term future of our society. Decades of growth and reasonably mild recessions, at least by historical standards, have fed the expectation that this will be the pattern that we will see over the next few decades.

The view of The Money Enigma is that this confidence in the long-term economic future of our society has had an important impact on containing the debasement of fiat money, despite the rapid historical growth in the monetary base. In turn, this support for the value of fiat money has kept a lid on prices as expressed in money terms.

Why does long-term confidence matter to the value of fiat money? And why does the value of fiat money matter to inflation? These are both issues that we shall address in detail in the last section of this post. But, in simple terms, the view of The Money Enigma is that fiat money is a proportional claim on the output of society. Therefore, the value of fiat money is positively correlated to confidence in the long-term economic prospects of our society.

Moreover, the price of a good in money terms depends upon both the value of the good and the value of money: all else remaining equal, as the value of money falls, the price of the good rises. If the market value of fiat money is relatively stable, as it has been over the past decade or so, then the price level should, all else remaining equal, remain relatively stable.

Anyway, let’s close the loop, as it were, on our discussion regarding the nature of the “virtuous cycle” that has been created.

The view of The Money Enigma is that the suppression of interest rates and monetary base expansion by the central banks has fueled a cycle of confidence that has underwritten economic growth and kept inflation at bay. However, this virtuous cycle will only sustain itself if expansionary monetary policy can continue to generate credit growth and economic growth and, perhaps most importantly, sustain market confidence in the long-term future of our society.

So, what might happen if we reach the point of “credit saturation”? What happens if expansionary monetary policy no longer has any significant impact on economic growth? Alternatively, what happens if aggressive monetary policy actually begins to undermine market confidence in our long-term economic future?

The Vicious Cycle of Credit Saturation, Falling Confidence and Rising Prices

Over the past fifty years, there has been an explosion in the level of private-sector credit, as measured against GDP, in almost every major developed and developing economy. However, over the past ten years, the growth in private-sector credit has slowed in many of those countries, despite record low interest rates.

While it may be too early to call at this stage, it does seem plausible that we are approaching a point of “credit saturation”, particularly in the United States, Europe and Japan.

What is the point of credit saturation? For the purposes of this discussion, it is the point at which additional monetary stimulus does not generate growth in private-sector credit.

Why might we be reaching the point of credit saturation? Well, there are a few reasons why this might be the case. First, demographics in many of these countries suggest that the consumer, in aggregate, should be moving into a deleveraging phase. Second, private debt levels are already very high by historical standards and common sense suggests that there is some natural limit on these levels.

However, the most compelling reason to believe that we are nearing the point of credit saturation is the most obvious: interest rates can’t get much lower than this. Admittedly, someone could have made a similar observation to this nearly ten years ago and would have been proven wrong. But, with short-end rates now at zero and long-end rates near record lows, it is hard to see how interest rates can take another big step down.

Why does reaching the point of credit saturation matter?

The reason it matters is because the point of credit saturation could represent the monetary policy “tipping point”, i.e. the point at which monetary base expansion stops having a positive net impact on the economy and begins to have a negative net impact.

Moreover, and perhaps more importantly, it may be the point at which the “virtuous cycle” becomes a “vicious cycle”.

How does the vicious cycle work? Let’s start near the top of the diagram above and assume that we have reached the point of credit saturation.

If credit growth slows to stall speed, or worse, credit balances begin to significantly decline, then this is likely to have a negative impact on the rate of growth that the major developed economies can sustain. Just as importantly, slower baseline economic growth will lead to sharper and more severe recessions. After all, if you assume that growth in the economy oscillates around some baseline or trend level of growth, a lower baseline will lead to lower highs and lower lows.

Clearly, such a change in dynamic, if sustained over any extended period of time, would begin to chip away at long-term economic confidence. If economic growth is anemic and recessions are more frequent and more severe, then market confidence in our long-term economic future will be eroded.

Now, we get to the critical point. If people begin to lose faith in the long-term economic future of our society, then the fiat money issued by our society will begin to decline in value. All else remaining equal, this decline in the value of fiat money will trigger a widespread rise in prices.

If this scenario occurs, then central banks could quickly find themselves trapped in a vicious cycle.

Declining economic confidence leads to a fall in the value of fiat money that, in turn, leads to a rise in prices. Central banks are forced to tighten monetary policy, which triggers a decline in credit balances and an extended period of economic malaise further eroding long-term economic confidence and the value of money. The end result is that inflation continues to accelerate, economic conditions worsen and people begin to wonder where it will end.

No doubt, there are many economists who would argue that this sequence of events is impossible. The narrow view of many economists trained in the Keynesian school of thought is that if the economy is weak, then prices must decline. In simple terms, their argument is that is less aggregate demand equals lower prices.

Intuitively, this idea seems plausible. After all, in microeconomics we are all taught that, all else remaining equal, less demand for a product will lead to a lower price for that product. Unfortunately, that represents a very simplistic view of the way the prices are determined, particularly at a macroeconomic level

What many economists don’t seem to appreciate is that every price is a relative measurement of market value. More specifically, the price of a good in money terms is a relative measure of both the market value of the good itself and the market value of money. If the market value of the good, as measured in absolute terms, is constant and the market value of money falls, then the price of that good will rise. (See “A New Economic Theory of Price Determination” for an extended discussion of this point.)

At a macroeconomic level, the price level can be considered to be a ratio of two market values. More specifically, the price level is determined by both the market value of the basket of goods (the numerator) and the market value of money (the denominator).

In a weak economy, it is likely that there will be pressure on the numerator in our equation above: if there is less demand, then the basket of goods becomes “less valuable” in an absolute sense.

However, this does not mean that price must decline in a weak economy. Why? Prices may rise and rise significantly in a weak economy if the market value of money, the denominator in our price level equation, declines by a greater degree than the decline in the market value of goods, the numerator in our equation. (See “Will Inflation Rise or Fall in the Next Recession?” for an extended discussion of this point.)

In summary, if credit and economic growth stalls and this damages long-term economic confidence, then the value of fiat money could decline sharply, leading to a sudden acceleration in inflation.

The Value of Money and Long-Term Economic Confidence

This discussion raises a couple of obvious questions about the relationship between economic expectations and the value of money. First, what factors influence the value of fiat money? Second, why is the value of fiat money tied to long-term economic confidence?

These are topics that we have discussed in many recent posts, but we shall address them both briefly here.

The first question is discussed at length in two posts that should be read together titled “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

In essence, the view of The Money Enigma is that fiat money is a financial instrument and derives its value from its implied contractual properties. Representative money (money backed by gold) derived its value from an explicit contract that promised a certain amount of gold on request. When we abandoned the gold standard, this explicit contract was rendered null and void.

So, why did paper money retain any value at that point? The view of The Money Enigma is that paper money retained its value because the explicit contract that governed paper money was replaced by an implied-in-fact contract.

Fiat money is a financial instrument. A financial instrument, by definition, only has value to one party because it is a liability of another. From an economic perspective, fiat money is a liability of society. More specifically, fiat money represents a proportional claim against the future output of society.

This theory allows us to begin to answer the second question raised above, namely “why is the value of fiat money tied to long-term economic confidence?

If fiat money is a proportional claim on the future output of society, then its value will be primarily determined by two variables.

The first variable is the expected rate of long-term real output growth. If fiat money is a claim to future output, then a higher expected long-term growth rate of output will make fiat money more valuable today.

The second variable is the expected long-term path of the monetary base. If every unit of the monetary base represents a proportional claim (or “share”) of future output, then expectations of higher levels of future money creation will lead to a lower value for each unit of money today.

The alternative way to state this is to say that the present value of fiat money primarily depends upon the expected long-term path of the “real output/monetary base” ratio. What determines the expected path of the “output/money” ratio? The answer is confidence in the long-term economic future of society.

If people are optimistic about society, then they should reasonably expect solid real output growth and constrained growth in the monetary base. However, if people become pessimistic about the economic future of society, then they may well expect low levels of output growth that are supported by high levels of monetary base growth. If people move from a state of long-term optimism to a state of long-term pessimism in a short period of time, then the value of fiat money will decline sharply.

In simple terms, the view of The Money Enigma is that “fiat money is only as good as the society that issues it”. What this really means is that the value of any fiat currency, and hence the price level of any fiat currency regime, is intimately tied to confidence regarding the economic future of that society. We have seen this simple principle demonstrated repeatedly. For example, think Zimbabwe in the 1990-2010 period.

While it is very unlikely that the Western World will follow a similar path to Zimbabwe, for a whole host of reasons, it does seem possible that the real test of our fiat monetary system is yet to come. If economic growth stalls as we reach the point of system-wide credit saturation, we may see the virtuous economic cycle that we have enjoyed turn into a vicious cycle of economic misery.