Yesterday we claimed that misunderstanding money has led to what, under Keynesian economics, is considered impossible: governments with outstanding debt far in excess of their ability ever to repay. This has led to the situation in Greece that has panicked the politicos, and has given us a vision of the future for the rest of the world, especially the United States. World debt has grown to the point where it is entirely conceivable that it is unrepayable. How is this possible?
If, as the experts who adhere to the Currency Principle assert, "money" consists of a general claim on the total wealth of an economy, there can never be more debt outstanding than the government has the power to tax and repay, even if the tax rate is 100%. This theory, however, fails to take into account what money really is, the fact that you really can't consume without producing, and that money creation must be accompanied by (ideally, tied directly to via the institution of private property) an increase in the present value of existing and future marketable goods and services measured in real, not inflated terms.
Greece's problem (and that of the rest of the world) results from the fact that the private sector, where marketable goods and services are produced, creates money in a slightly different way than the public sector, that is, the government, which by its nature produces nothing in the way of marketable goods and services.
The private sector creates money backed by the present value of future marketable goods and services by "drawing bills." These "bills of exchange" — in 2008 estimated at roughly 60% of total transactions in the U.S. economy — can be used directly as money (trade or merchants' acceptances), or taken to a commercial bank and discounted in exchange for the bank's promissory note, which can then either be used directly as money, or used to back a demand deposit. Assuming that the drawer of a private sector bill of exchange is not engaged in fraud and drawing "fictitious bills," the exchange value of such bills is determined by the present value of the marketable goods and services in which the drawer has a private property interest, the value of which he or she has pledged to deliver when the bill is presented for redemption.
The public sector, "the government," also creates money backed by the present value of future marketable goods and services by drawing bills. These "bills of credit" (the "constitutional term" for bills of exchange emitted by a government to be used as money directly or exchanged for other money) are not, however, backed directly by the present value of existing and future marketable goods and services in the economy. Except in a socialist State, the government does not own that existing and future production. Rather, bills of credit (also called "anticipation notes") are backed by future taxes to be levied on existing and as-yet uncreated marketable goods and services that belong to the citizens.
Inflation comes in because most of the existing marketable goods and services in the economy already have bills drawn on their present value. This means that every time the government emits a bill of credit, it is adding another dollar to an existing dollar, creating two claims on the present value of an existing marketable good or service where there was only one before.
To make matters worse, existing marketable goods and services are consumed after being used to redeem the private sector bills of exchange drawn on their value, leaving the government bills of credit not backed by anything other than the government's own promise to pay . . . out of taxes collected on wealth (marketable goods and services) that no longer exists. When carried to extremes, as was the case in Germany and Austria-Hungary following World War I when Allied "reparations" stripped the countries of virtually all productive capacity, the currency ends up worthless and the price level rises faster than new money can be printed: hyperinflation, an example of what happens when you try to divide by zero.
But wait! There's more — which we'll get to tomorrow.