The Debt Paradox

0:00 On August 15th, 1971, American families settled in for their favorite TV show when Richard Nixon interrupted. I have directed Secretary Connley to suspend temporarily the convertability of the dollar into gold. It was the biggest peacetime power grab in human history. After this moment, America became the banker in a global game of monopoly and could never run out of money ever again. We are truly in this country like an incredibly I mean incredibly rich family. Consider what happens when the banker runs out of money. The monopoly rules say when it runs out the banker can simply cut strips of paper and write down new money. This is how the global financial system worked after this moment. Game money became US dollars and

0:46 only the US could create it. Today the US government has over $36 trillion in debt. Yet, the debt is in money they can create at will. And people are sharply divided on what it means. The $35 trillion in debt, we're going to pay it off. We're no longer on a gold standard. So, finding the money to pay for the things we need is never an issue. Both sides of this debate hinge on a paradox. Why would a government that can create money need to borrow it at all? To understand this strange situation, we need to go back before paper money, before metal money, back to when money was food. Imagine a world with no money, just people, land, and time. And people use time to get food. In early

1:32 economies, rice wasn't just food, it was money. If it takes 8 hours to gather 10 cups of rice, and you want to trade for it, I'll value your item based on my rice gathering time. This is the foundation of the labor theory of value which says the value of something should be linked directly to the labor needed to produce it. And so having extra rice gives you extra power because you can trade it for someone's time. And as people store surplus rice, those with large food stocks gain control. But there is a limit. Commodity money such as rice is limiting because it spoils, it's bulky, and hard to transport. This drives the need for a more durable, portable form of wealth, which leads to

2:17 our next form of money, token money. Every culture discovered the same truth about money. Rarity creates value. From shells to precious stones, human treasure, what's hard to find. But what was treasure in one place might be worthless everywhere else. For trade beyond local regions, the world needed something everyone would value. Then this is why gold emerged as a perfect solution, universally rare and desired and became the first truly global money. And so when the powerful converted their food stocks into gold, you could hold the power in your palm. A handful of gold might represent hundreds of people's labor over many months. But now

3:02 we face a crucial question. How much gold equals how much rice? To understand prices, let's imagine two tanks connected by a market wheel. When a buyer drops in gold in one side, the wheel turns and delivers rice from the other tank. Price emerges naturally as the gold people are willing to spend balances against the rice available. If there's 100 gold coins circulating and 1,000 bushels of rice for sale, price eventually settles at one gold coin for 10 bushels. But if a drought cuts rice harvests in half and there's only 500 bushels available with the same amount of gold trying to buy half as much rice, sellers raise their prices to protect their dwindling supply. If they didn't,

3:50 they would quickly run out. And so now one gold coin might buy around five bushels. This is supply side inflation. But with a bumper harvest, doubling the rice to 2,000 bushels, there's not enough gold to buy all the rice at the old price. Sellers lower prices to move their stock before it spoils. Now, one gold coin might get you around 20 bushels of rice. This is supply side deflation. And the same happens if we change the money available, what we call demand side inflation or deflation. But these price changes affect people in dramatically different ways. This video is sponsored by Abacus AI. I find myself jumping between a bunch of different AI tools and it can get messy and

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5:23 borrows 10 gold coins and gradually sells them for rice to pay workers over a season. If the value of gold doubles by the time the farmer needs to pay it back, they need to sell twice as much rice to repay the same 10 coins. So deflation crushes debtors. Meanwhile, someone who saved 10 gold coins is delighted. Their savings now buy twice as much rice. Deflation rewards savers of money. With inflation, gold money becomes less valuable. That farmer who owes 10 gold coins is relieved. Their debt shrunk. They can repay by selling half as much rice. Inflation helps debtors. But our saver watches their purchasing power erode. Their 10 coins

6:10 now only buy half as much rice. Inflation punishes savers. Stable prices are the fairest because neither debtors or creditors get an unfair advantage. But here's the problem. Modern societies naturally produce more and more over time. Farming improves, technology advances, productivity increases. With fixed gold supply and growing output, we face constant deflationary pressure. So money tends to want to expand to match growth. But the most fascinating way isn't to create more, but to make people use what exists more frequently. The best example is during the Great Depression's crushing deflation. The Austrian town of Vergal

6:56 tried a radical experiment, money which lost value by design. Each month you had to buy a stamp and stick it on your money to keep it valid. These stamps were around 1% of the money's value and this created pressure to spend it rather than save it. Otherwise, it would lose a value of 1% per month. The results were extraordinary. Their modest money supply circulated 463 times in just 13 months, generating economic activity as if they had 40 times more currency, allowing the increase of work, goods, and services traded, which we call gross domestic product or GDP. It's how we measure the power of an economy. Think

7:43 of GDP as a collection tank capturing all the economic activity flowing through the market yearly. Unlike our money tank or our goods tank, the GDP tank measures flow, how much actually gets done. And this brings us to a famous equation. M * V= P * Q, where M is the money supply. V is the velocity, how many times each unit of money changes hands per year. P is the average price of goods and services and Q is the quantity of goods and services produced. And so when economists talk about GDP, they're measuring P * Q, the total value of all goods and services. And so economic output can grow by having more money or by having more money move

8:30 faster. The next kind of expansion happens by force. So we need to add another player to the picture, the government. In ancient gold economies like the first Italian citystates, governments typically managed money through a simple taxation cycle. Spend money on public services, defense, and administration and then tax that money back from the economy. But Venice faced an extraordinary crisis in 1171 when the Bisantine Emperor suddenly ordered the arrest of all Venetian merchants and seized their warehouses, ships, and trading goods across his entire empire. Venice had to respond with immense force. They needed to build over a 100 warships as fast as

9:16 possible, which demanded massive spending, far more than their tax collectors would ever gather. Their solution was forced loans. Wealthy citizens had to lend gold to the state for paper certificates promising 5% annual interest. One of the earliest examples of a government bond or an IOU. And the government immediately spent the gold they collected back on armies and ships, pushing it back into circulation, while the paper IUS or bonds also began circulating as money. So Venice effectively doubled its money supply. The same gold that built ships was now in workers pockets while the bond representing claims on that gold also circulated. And these bonds

10:02 introduced something new, a floating value based on trust in government. When Venice was winning and trade booming, people valued these bonds highly. One bond dollar equal one gold dollar. During crisis, when people doubted the government's ability to pay, value plummeted. At the lowest, people paid 20 cents on the dollar for the Venetian bonds. So, they worked kind of like a prediction market. This marks the third kind of money. While the governments pioneered it, the free market would truly unleash its potential, debt money. When goldsmiths made a discovery that would transform money forever, goldsmiths at the time had trusted secure vaults and they accepted gold deposits from merchants and wealthy

10:47 citizens and gave them back paper receipts, promises to return gold on demand. And people found it easier to trade receipts than carry heavy gold. So the paper itself became money. Then came the pivotal observation. Goldsmiths noticed that only 10% of the deposited gold they held was ever withdrawn at one time. 90% of it just sat idle. Why leave it there? So, they started loaning idle gold out to trusted people. When someone needed a loan, the goldsmith would give them actual gold from the vault and take an IOU, which was a promise to repay with interest. So, they traded physical gold for a customer paper IOU.

11:33 But these borrowers typically deposited that gold right back into the vault since paper receipts were way more convenient. So if you zoom out and consider the whole system, it created a multiplier effect. You'd start with 10 coins being deposited. Then they would keep 10% in reserve or one coin and lend out the other nine. Those nine eventually get redeposited for paper notes. Keep 10% of that, lend out the remaining eight coins. Those eight coins get redeposited and so on until you're down to your last coin. Through this process, the 10 original gold coins ends up supporting 100 coins in paper IOU form. So the money supply expanded 10fold due to the 10% reserve

12:18 requirement. And so from that moment roughly 90% of money in the world took the form of this debt money. Bankers soon took this logic to its ultimate conclusion. If people accept paper receipts as money, why lend the gold at all? When someone needs a loan, just create new banknotes, same as the paper deposit receipts from before, and give it to them, and the borrower trades their paper IOU, which is a promise to repay,

13:05 and no gold moves at all. They simply trade paper IUS for paper IUS. The loan itself creates the new money that did not exist before. This was arguably the most profound shift in monetary history. The power to create money from promises would become the foundation of our modern financial system. But they didn't stop there. Banks soon realized they held another form of money, the IUs from the borrowers. These weren't the circulating banknotes. These were the private promises from customers to repay loans that the banks were holding in their vault. But a king's IOU, well, that was good as gold. And famously in 1672,

13:52 London's goldsmith bankers held massive IUs from King Charles II. These royal promises seemed like the ultimate money and the bankers made a fateful decision. They used these royal IUs as collateral to borrow from other banks and expand lending. This created chains of credit. The king's IOU supported loans to Bank A and Bank A loans backed by this royal debt supported loans to bank B. Bank B used these promises to extend credits to merchants. Merchants use this credit to fund trade ventures, leading to a massive tower of credit, all based on a single promise. Disaster struck when King Charles II announced he would stop payments on his debts. This is a distant echo to what happened

14:38 in 2008. Their customers are freaked out waiting to see how low the Dow will go. They're focused on the Dow, not so focused on OPEC. Yes, OPEC did cut production but except that it was mortgage IUS at the bottom of that tower and the crisis revealed how the entire monetary system rested on chains of trust and so the government had to step back in and this is where the power grab begins. The bank of England transformed the financial system by creating a new layer above the banks. It became the bank for the banks known as a central bank. To join this system, banks brought cash and gold to the Bank of England and received reserve credits in return, just numbers in the central bank's ledger. This is known as base money, and only

15:24 the Bank of England could create it. The reserves the banks held with the central banks limited their capacity to lend. They required their total loans to be backed by roughly 10% of reserves. If public confidence in one bank failed, such as from a bank run, the central bank would provide emergency funds or liquidity, which prevented the crisis from spreading through the system as before, like a fire extinguisher for financial panic. The Bank of England's relationship with the British government revealed an extraordinary power hidden within the central banking model. For example, when Napoleon threatened Britain's survival, traditional methods couldn't generate the resources quick enough to fight back. So, they pulled the ultimate money trick. The government

16:10 issued new bonds. The central bank created new money to buy these bonds and then the government spent this new money into the economy. This was a roundabout way of the government printing money and giving it to themselves. And the USA borrowed this idea when it created its central bank, the Federal Reserve, in 1913, known as the Fed. And the Fed used this power on an unprecedented scale during World War I and two to supply our men in battle with everything they need and buying and holding war bonds. I buy bonds every payday and I hold all that I've bought. When this scrap is over, I'm going into retirement and do lots of

17:04 fishing. During World War II alone, the Fed almost doubled the money supply. But this massive money creation didn't trigger runaway inflation during the war because the money had somewhere productive to go. It matched the enormous expansion in the production of tanks, ships, and planes, resulting in a dramatic spike in GDP. The key insight is that money creation works when there's productive capacity to absorb it. Instead of just bidding up prices, the money flowed into real economic activity. Though other countries, especially those on the losing side, did not have this luxury to print money freely without inflation, leading to a critical mistake many made. Most notable was Hungary who printed money to buy US dollars. They needed those US dollars to

17:50 pay foreign debts and import basic goods as nobody outside their country accepted their currency. And so to get these US dollars floating around their economy, the government had to print larger and larger bills to buy them. By 1946, they released the largest note ever, a 100 quintilion pango bill. And within days, the entire money supply of Hungary could not buy a single US cent. And by the war's end, the United States owned about 60% of the world's gold reserves. They had more gold than dollars in circulation. Their money was actually overbacked by gold. And at Bretton Woods in 1944, America leveraged this position to consolidate power over money.

18:36 At Bretonwoods, New Hampshire, delegates from 44 allied and associate countries arrived for the opening of the United Nations Monetary and Financial Conference. Before this moment, every country's currency was convertible to gold at some ratio. But now only the US dollar would be convertible to gold at $35 an ounce. All other currencies would be pegged to the US dollar at a fixed exchange rate. And this created a hierarchy in the global monetary system. And this system worked while America maintained discipline and had the gold reserves. But by the 1960s, two forces strained it. One was massive US spending in Vietnam War and their Great Society programs domestically known as the guns

19:22 and butter era. This leads to a fundamental contradiction. The world needed more US dollars for trade and reserves, but creating those dollars undermined their gold backing. And by 1971, foreign governments held many more dollars than Americans had gold to redeem them. And they knew it. Countries like France and Japan resented that the USA could simply spend money freely, which everyone else had to treat like gold and carefully manage.

20:11 and they called America's bluff. Countries like France began quietly converting US dollars to gold since they knew it couldn't last. And gradually the gold drained out of the USA into other countries. And a crack finally formed as the market price for physical gold began trading above the official $35 an ounce price. The free market was declaring that America's promise was mathematically impossible. The gold backing a dollar was worth more than a dollar. So America faced a choice. either they could restrict dollar creation to maintain gold convertability

20:58 or they could abandon the gold link entirely. And that's what Nixon did. He cut gold out of that hierarchy and put USA at the top. And so Nixon took an ancient idea and applied it globally for the first time. Think of country fair tickets. Inside the fair, they're valuable as cash because you must use them for rides and food. outside the fair. They're worthless paper. Their value comes from the authority requiring their use. Known as a fiat currency, fiat money had been created many times throughout history, but it was always a regional money working in one area. Nixon's innovation wasn't just creating fiat money. It was making the entire world America's fair.

21:45 And the Federal Reserve became the ultimate authority on money, the new apex of the global banking system. So, the Fed's central bank ledger became the world's super ledger, the ultimate source of all dollar creation. Every bank on Earth connected to this system, either directly or indirectly through other banks. So, this leaves us with a three tier monetary world. At the top is the United States, the only banker who can create the world's money. Below that are countries with their own currency, such as UK, Japan, or Canada. And the bottom tier is everyone else who doesn't create their own currency. They must earn or borrow dollars to get them. To understand what this means for each tier, let's return to the most basic economic unit, putting food on the table

22:30 at home. From now on, why don't we both write down every cent we spend. Think of your family as a mini economy. Parents earn income and pay expenses. And if a house spends too much and runs out of money, their last resort is to borrow on credit, giving a bank an IOU in return for loaned money. And if the interest rate they borrow this money at is higher than their income growth, the household will fall into debt and they will default on their loans and eventually lose everything. And realize like families, local governments face this same constraint because they don't make their own currency. They have to balance their budget or fail. And this also applies to countries that don't create their own currency, such as when Greece joined the euro, they gave up their ability to create money. And so when

23:17 Greece or Spain needs money, they must borrow from the market by selling bonds, which leads to a critical point, bond yields. When Greece issues a $100 bond promising €3 annual interest and it initially trades at €100, it offers what we call a 3% yield because yield is the annual interest the government promises divided by what you paid for the bond. But if investors lose confidence in the bond and the price drops to say €50, because the government is still paying €3 annually, the yield doubles to 6%. This higher yield reflects increased risk. And so think of yield as a critical market signal of confidence in government. And what happened in Greece is the bond sell-off continued until

24:04 Greek bond yields hit 35%. These high yields dictated future borrowing costs. So this meant Greece would need to offer 35% interest to borrow any new money, leading to collapse. The government ultimately defaulted, paying bond holders only a fraction of what they were owed. And now let's turn to the next tier, which is countries that do create their own currencies. They have another option when they run out of money. They can create new money via debt monetization, as we've seen. But there's a catch. An economy can only absorb new money up to the productive capacity measured by GDP. And when money creation exceeds what the economy in that country can absorb, we get inflation. General price rises across the economy. This creates an important relationship between growth, inflation,

24:51 and yields. Bond yields roughly equal the expected future GDP growth in a country plus the market's expected inflation in that country since people want to make enough interest to cover the losses due to inflation as well as match what the economy is creating. So, a country growing at 2% and expected to have 5% inflation will see their nominal bond yields rise towards 7%. And so, what's fascinating is while a bond initially has a price set by the government, it's the market price that ultimately determines the yield, which is outside of government control. This brings us to the final tier, the United States. The dollar isn't just America's currency. It's the world's primary

25:37 reserve currency used in roughly 90% of foreign exchange trades and makes up about 60% of foreign central bank reserves. This global role provides America with a powerful buffer against inflation that no other country enjoys. When the USA creates new dollars, they don't just circulate domestically in their economy. They flow out into the global economy through trade, investment, and foreign reserves. Since everyone needs these dollars, this means the US can create more money than other nations before triggering inflation since the impact is spread across the world. This unique position lets America issue their bonds known as Treasury bonds far beyond what other nations could attempt. These Treasury bonds form

26:22 the base of global finance as the world's risk-free investment. Every other interest rate in the world builds up from US Treasury yields. Other government bonds yield more than US Treasury bonds. Corporate bonds yield more than the government bonds. And consumer loans for cars and houses yield more than the corporate bonds. When the Treasury yield rises just 1%, it ripples through the entire system, triggering roughly 3 trillion in additional borrowing costs worldwide. So these aren't just America's interest rates, they're the world's interest rate. And so one relationship determines the sustainability of this entire system. When the economic growth or G exceeds the Treasury yield R, the US debt remains manageable. But if Treasury

27:09 yields rise above growth, the debt service costs begin consuming an ever larger share of economic output. And this indicator serves as the ultimate measure of America's monetary power. There are two ways this delicate balance can break. First, if too many dollars flood the global economy, the markets react by pushing the Treasury yields up as investors demand higher returns to protect their wealth from inflation. And the second threat is even scarier. Realize that when foreign countries earn US dollars from trade, they don't just hold cash, they buy US Treasury bonds to earn interest and protect against inflation. This has created what economists call a financial balance of terror. Because if major treasury

27:54 holders like China and Japan and oil producers ever coordinated to sell these Treasury bonds together, the yields would spike worldwide. This would force crushing debt payments not just on America, but on every government, business, and homeowner with a loan. This is why it's referred to the economic nuclear option for every country to dump their Treasury bonds. Yet, despite these risks, the system endures. When the US spends more than it takes in and runs a deficit, that money becomes private sector wealth, dollars in the pockets of citizens and businesses. And so while the US government shows 36 trillion in national debt, if you look at the other side, America's hold over 150 trillion in

28:40 total assets, this is one reason the market remains confident despite the scary numbers on debt. And so America faces one fundamental constraint, global productive capacity. When too many dollars exist globally, even the world's economy can't absorb them all, leading to global inflation. This would be the ultimate check on monetary power. And so Nixon's decision in 1971 completed this transformation, detaching money completely from physical reality. Today's dollars are not backed by gold in any sense, but by the strength of the economy using it and our collective faith in the future. The true reserve currency isn't the dollar. It's our shared belief. Nobody knows how far you can

29:27 go with the paper currency before it gets out of control. If and particularly if you're the reserve world's reserve currency, nobody knows the answer to that. And you don't want to try and pick out the point at where it does become a problem because then it's all over. Thank you so much for watching this video. If you would like to stay uptodate on new videos and projects I have coming, please join my email list. I have something coming up I think you'll be interested in.