Bank Loans Hedge Against Inflation Risk

on Tuesday, February 22, 2011

The currency we use today is asset-backed, but it's not obvious to us. Most dollars come into existence when a bank makes a loan for a home, car, or business, all of which are assets and back the currency. A bank creates money with every loan, but the money isn't really "debt-based." That's a confusing term.

Creating currency is very simple. If I bake an apple pie and go to a bank, I would first give them the pie and they would give me eight IOUs for one piece of apple pie. Now they own the pie and I own the paper IOUs. But what if I want to hold the pie and have the paper at the same time? The bank would offer to loan the pie back to me at interest, say one piece of pie per year. I would take the pie back to my house and pay them one piece of pie in interest and another piece in "principle" each year until the pie is paid off.

The same thing happens with a house, but ownership changes hands with contracts, and buying a house is more confusing than building a house because there is a third party involved, but the process is the same. The bank takes ownership of the house and gives the old owner IOUs (US dollars) from the Federal Reserve Bank in exchange. They then charge interest to the person living in the house (a house the bank now owns), and the person living in the house pays the IOUs back to the bank slowly over time.

Every dollar is "backed" by the original asset. It can be apple pie or a house, it doesn't matter. We can create a currency with any asset, and government decree does not make the currency valuable. Almost every dollar out there is instantly exchangeable for real assets. You can pay off your home or car loan at any time using US dollars, which is the same as walking into a bank and demanding gold for the dollars. Cars, homes, and gold are all assets. Even if the government prints 100 trillion more US dollars, you can still go to the bank and take ownership of your home or car that backs the dollars you hold.The only way to remove the asset backing of the currency is to have banks stop accepting them in payment for the loans on their books.

Many people currently feel that the gold standard is a good thing, not because it forces paper money to hold real value, but because it restricts government's ability to spend rampantly with the help of the printing press.  Until recently, I have generally regarded this to be a sound argument, but today I am not sure it is correct. US currency can be exchanged for an asset at a fixed exchange rate as well. The exchange rate is on the mortgage paperwork. What is the difference between being able to always exchange the currency for gold or always being able to exchange it for a home? What is the fundamental difference between walking into a bank with $100,000 and walking out with 100 ounces of gold... or walking in with $100k and walking out with the deed to a home worth 100 ounces of gold?

Another common idea regarding paper fiat is the idea that the currency (the physical paper) has zero ability to store real value, and that gold-backed paper, or exchanging gold itself does hold real value; and that the fiat currency is entirely dependent on government enforcement to continue.

The problem with this idea is that paper money would occur without government backing or force and US dollars do hold real value; each dollar is a debt from a bank, and debt agreements are assets and have real value, just like a bond. Fiat dollars are debt agreements and hold real value in the same way. If the bank spends fake IOUs they go down in value but they are still exchangeable for the original asset. If they dumped 100,000 bank notes on each person's lawn, you could still exchange them for ownership of your house. That loan agreement can't be inflated away.

Even with a gold standard the bank can spend "fake" IOUs and hope no one notices. An IOU for gold is not fundamentally different than an IOU for a house. They are both assets with real value and the bank note is still a debt agreement in either case. The asset the bank takes in exchange for the bank note does not matter, and it doesn't stop a bank from printing fake IOUs if it is forced to exchange IOUs for gold. It is already forced to exchange those IOUs for other assets (homes, cars). The gold is a red herring.

An additional somewhat incorrect idea regarding fiat money is that the printing press always has the ability to destroy wealth held by people holding the currency.  This is not always the case, and depends on two factors: the amount of cash held by an individual and the amount of outstanding bank debt that person holds. For example, if I live in a house worth $100k and I hold 100,000 US dollars in my mattress, my cash holdings are worth "one house." I can pay off the loan and hold the deed to the house tomorrow. My net worth would be one house.

If the currency base is doubled overnight, I can still go to the bank, pay off the loan with the (now devalued) cash, and hold the deed to the house. The doubling of the monetary base would not affect me at all, my net worth is still "one house," and the house's value relative to other assets has not changed. If I held $100k and no bank loan, or if I held $200k in cash and held a $100k bank loan, only then would the doubling of the money supply affect me. Bank loans can be used as hedges against inflation.  If a person has matching debt to cover his cash holdings, his inflation risk is close to zero.

Long term storage of wealth can also be accomplished by owning stable assets that are not currency, but the primary problem with only one currency legal in the US is that it's hard to conduct business transactions with an unstable and inflationary currency that has a higher than normal risk of failure and no competing currencies. I can't pay for a taco in Euros. If I could, we'd have a much more stable economy in the US. 

The real way to stop inflation to stop allowing one bank to have a monopoly on currency production. If the bank can never fail unless the nation fails, that's a recipe for disaster. If a bank can die if it is caught printing fake IOUs or if people can easily use another bank's notes instead, that competition and fear of failure would keep banks in line, stop inflation, and create stable and reliable banks who don't cheat, hold assets to back every bank note, and maintain a very stable value over time. Additionally, government would have no ability to print money. They would have to pay for things with real money; taxes paid in various currencies from each independent bank. The real danger isn't a lack of assets or gold that backs the fiat and keeps government from spending, it is that government controls the business of currency production and explicity bans anyone else from entering that business.