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DURATION and PERPETUAL DEBT

Sandeep Jaitly, Director of Economic Research Gold Standard Institute, Vienna

14th September 2010 THE roots of our Great Financial Crisis have not had any true light shed upon them by the wider economic community partly because they are objective-value in stance, but principally because they have little grasp of physics. The avaricious nature of the western consumer; the resultant huge distortions between creditor and debtor nations and the stratospheric leverage of the financial system to name but a few of the reason proffered. These are grave problems for sure; however they overcomplicate the issue unnecessarily and are symptoms of a malign financial system rather than its cause. Why does this paper exist? The aim of this paper is to show...

The essential problem of the current monetary regime is the mismatch of durations of financial assets and liabilities. The shorter mismatch of durations presents perennial problems for the monetary system. Combined with perpetual debt the problem is exponentially amplified. This outcome is a direct consequence of abandoning that physical substance, which has the propensity for its utility at the margin to decline the least, as the monetary unit of account.
To get to the route of our problem it is important to start from first principles. In the beginning silver was money. The recursive procedure by which the people themselves determined the most marketable item produced silver countless millennia ago. The acquisition of silver as the most marketable good presents problems of a physical nature. What does the successful merchant do with their accumulated stockpile of silver beyond that needed for daily expenses? What does the prudent and thrifty individual do with their large stockpile of silver? For that matter what does anyone who has a surplus stockpile of silver do with it to ensure its safety and security? The concept of the safe storehouse is born. Individuals worried about the theft of their silver holdings kept domestically can entrust them to a respected individual with safe storehouse facilities. Just think of the necessary traits and character of the person to whom you would entrust the storage and safekeeping of your silver. Not any old pleb with a secure warehouse and key would do, but a person of utmost ethics and standing. Temples were the first institutions that had the privilege of safeguarding the peoples money.

The priests of the remote past who had sacrificed personal material gain were deemed superior to warring kings or acquisitive merchants in the safeguarding of the monetary balance. The entirety of ones silver holdings is not usually needed on demand. Demand means physically keeping the silver coin at home or keeping with receipt at the storehouse. The amount of silver that would be needed on demand, say, might cover day to day living expenses: clothing; food; transportation etc. You deem, say, that only 10% of your silver holdings are needed on demand for such purposes, the remainder is not. It is an entirely subjective decision. It is the remainder of ones silver holdings not immediately required that is effectively put to use to create the principle of the silver bond and the associated counterpoint of the time deposit. This is the time preference element of the creation of the interest rate bid-offer spread in action. The initiation of a loan for productive enterprise could be fashioned from one individual, say. It would naturally be fashioned from silver that is not required on demand. The dispersal of loan proceeds by the borrower for the productive enterprise creates a subset of individuals whose aggregate increase in physical silver coin is a sum no greater than the amount initially lent.

Each one of those individuals is then at the very least, and certainly at the margin, in the same position as the person who fashioned the loan in the first place: they will have a [marginal increase] in their silver balance which can subjectively split into what is required on demand and what is not. It is very important to understand this concept. Multiplier is an insufficient and inaccurate description of the process: recursive would be more suitable as would iterative, or self-similar. It is also worth remembering that ones own pecuniary position is the result of this process as well. By the beneficence of others with regards to their preference for demand versus non-demand ones own personal silver balance is greater (or not.) The result of the dispersal of silver coin through the spending of loan proceeds creates a system comprised of demand deposits and time deposits of varying maturities. The storehouse which was initially there to keep silver on demand, could now branch out into lending silver which is in excess of any individuals demand requirements. The determination of the proportion of any individuals silver that is required on demand is a purely subjective process. It is certainly not the prerogative of the storehouse owner. The subjective determination of silver required on demand coupled with the recursive procedure detailed above gives rise to a system of financial assets and liabilities that match perfectly in duration by subjective definition.

Note that the concept of time deposit and bond is not dependent upon the existence of a literal storehouse. They can be pure concepts of the mind and just noted mentally. Of course, it is much harder to look for a secondary market price for a bond that exists only in the mind as opposed to a bond that exists in legally documented and notarised form. The successive entrance of storehouses into the lending game was effectively a form of market making. They reduced the bid-offer spread between those that wished to borrow silver and those that wished to lend it.

Demand deposits are automatically (strictly by definition) covered 100% by physical silver coin. It should be evident that the extent of time deposits and the associated bonds has no limit in aggregate attached to it it is certainly not dependent on the amount of physical silver in the system. Consequentially, there is no physical limit (up to reluctance at the margin to lend) to the ratio of time deposits to physical silver. It is not difficult to see how this perfectly stable and subjective mechanism could be usurped by unscrupulous characters. The most obvious fraud would be for the storehouse owner to lend demand deposits for any length of time. In this case, cash silver balances would not match one to one with deposits on demand. Should a person require access to their demand deposit and there is insufficient cash silver because of this, then whatever the cash silver was invested in by the storehouse owner will have to be liquidated in a secondary market. Alternatively, the silver required could be taken from the storehouse owners equity capital. Either way this is nefarious and fraudulent. Although not fraudulent, the lending of silver for non-productive enterprise, or to put it bluntly, lending for dubious activities where there is no guarantee the principle debt can be amortised will cause problems at some point. What would be the consequence of lending to such characters in the case of a default? It would be the wide scale destruction of the relevant time deposits (beyond the equity capital if any of the financial system.) Default would be characterised by the bond in question not being paid back at all, or the secondary market price of the bond being well below par expectations. The wide scale destruction of time deposits would lead to assets (financial and real) being sold on their relevant secondary market should there be a bid. This is done in order to cover any loss potential or real to the time deposit system. It is quite clear that the resultant environment would be one of falling prices. However, this has nothing to do with reduction in consumer demand but is a result of the aforementioned process of deposit destruction. Clearly, manipulative methods to increase consumer demand do not understand the true cause of a declining price environment and would be lacking by their very nature. To summarize at this stage: the lending of demand deposits is fraudulent, and lending for non-productive enterprise could cause catastrophic problems to the deposit mechanism. HOW has the current state of the financial system evolved from the ideal? The current financial system is not characterised by either fraudulent lending of demand deposits or lending to non-productive enterprise, but both. The first step on the road to our financial Armageddon was made when the storehouse owner, having graduated to a licensed commercial bank many centuries later, was allowed by the authorities to only keep a fraction of the physical silver coin behind demand deposits.

Anyone that went to a commercial bank seeking demand deposit facilities would be shocked to learn that only 10%, say, of their demand deposit is kept in physical silver coin as supposed to the 100% required. The 90% of the demand deposit that was fraudulently lent out would naturally be in secure, liquid investments like government bonds (!) which have a deep secondary market. What if the secondary market has a dearth of bids and there is a high demand for cash? The newly created central bank would be there to repo any eligible assets against a cash advance. The ratio of physical cash silver to total deposits (both demand and time) is distorted beyond the natural determination by subjective preference. Duration mismatch is born. This is also known as borrowing short to lend long. The second step on the road was made when lending to the government became the main preoccupation of the banks. These loans never tended to be amortised at expiry, but merely rolled on. Combine that with the recent practice of lending to anyone and everyone regardless of their credibility and there is a disaster waiting to happen (which did in 2008.) Government debt of any duration rolled into perpetuity is effectively a perpetuity, but without the funding base of a perpetuity. Lending to characters of dubious credit will eventually show up in the form of defaulted bonds which tend not have much value. The financial systems asset base is mainly composed of quasi-perpetuity government bonds (without perpetuity funding) and sour paper collateralised by illiquid assets.

- It must be appreciated that funding any loan with a funding source that is not of equal (or greater) duration is in effect equivalent to lending out demand deposits.
Silver is still assumed to be the unit of account. In this scenario of financial assets composed of government bonds and other forms of paper collateralised by illiquid assets, should there be any deterioration in the quality of the assets, or an increase for the liquidation of demand deposits into physical coin in excess of the banks physical coin balance, then there would be a massive impact on the secondary markets bid for these assets. An avalanche of offers for paper will hit a likely dearth of bids. The consequence would be wide scale destruction in the book value of demand deposits as well as a shortfall on time deposits coming due. People would find that when they went to their local bank, they would not be able to make a withdrawal against demand receipts, let alone time receipts with a penalty. The bank was said to be bankrupt and the liquidation of assets in a weak market the next step in order to pay back depositors. Fractions of the original sums deposited would be achieved. Such happenings characterised the banking system frequently over the centuries and this was all due to the mismatch of duration and thoughtless allocation which are catastrophic individually let alone together. The final step was abandoning silver and gold as the monetary unit of account. This allows one to paper over the fractured realities (mentioned above) with debt rolled into perpetuity that would have nevertheless occurred under a silver standard from a combination of duration mismatch and poor allocation. Deposit write downs were still at stake under a fiat standard...

...That is up until 2008, when the wider world realised there might be a problem in high finance, people were blissfully ignorant to the accumulated problem that will necessarily arise from breaking natural principles. Not only were the individual banks at risk as is commonly known but the entire deposit base of the financial system was at risk as well which is not commonly appreciated. No payments would have been processed. Deposits would have disappeared. The majority of people would have been left destitute. Prices of all varieties of good and assets would have collapsed as everyone sought physical notes and coins. Imagine the price of a standard home falling 95%. Imagine the price of a cup of coffee going back to one shilling. This would have happened had the governments of the world not stepped in. The purchasing power of a Federal Reserve note would have regained 95 years of losses. The mismatch of durations combined with effective perpetual government debt explains the destruction in the purchasing power of the fiat Dollar over the decades. Not the linear quantity theory of money. A lot of that loss in purchasing power would have been regained in a few months at the expense of the continuance of western civilization. The graph of bank reserves would have been similar to the increase in the purchasing power of Dollar (physical) note and coin were the system allowed to implode upon itself.

However this did not happen. The governments of the world effectively nationalised the entire deposit system. This is unprecedented. The natural determination of durations has been so grossly distorted that the only salvation is to nationalise any form of loss. This is only possible under a fiat standard. This is how the current situation is arrived at: first an utter degradation in the character and nature of the individuals charged with banking privileges occurred; then the introduction of fraudulent practices of lending demand deposits and financing assets of a much greater duration than the underlying funding. This was accompanied by consistent banking collapses and panics, as one might expect. The icing on the cake was the removal

of silver/gold as the unit of account in order to bypass these phenomena. This has not occurred nor will it ever. The self-regulating and self-correcting mechanism of the silver based demand and time deposit mechanism has been morphed into a system that is more likely to experience catastrophic resonance. WHERE now? The nationalisation of the deposit system will have grave consequences for assets prices (financial and real) in general going forward. A system which should have imploded under its own [mismatched] debt burden was not allowed to. Nor will it ever be from a deposit integrity standpoint. No longer is Mrs. Smiths 3-month time deposit with Northern Bank at risk. Nor is anyones anywhere in the world to all intents. An economic expansion nothing more than the consequence of nationalising the deposit mechanism is likely to ensue. But this will be no real economic expansion merely a nominal one. The stock market shall soar not because of exponentially increasing productivity, but because the deposit end-game was never allowed to be concluded nor will it ever be. Has this paper shown what was intended? Yes

The essential problem of the current monetary regime is the mismatch of durations of financial assets and liabilities. The shorter mismatch of durations presents perennial problems for the monetary system. Combined with perpetual debt the problem is exponentially amplified. This outcome is a direct consequence of abandoning that physical substance, which has the propensity for its utility at the margin to decline the least, as the monetary unit of account.