Our paper money system is based on debt – How long will it continue to function?

For many, today’s monetary system seems self-evident. People pay with notes, cards or smartphones without giving any thought to the origin of money.

Behind the expansion of the money supply lies a fragile foundation: Debt. Our paper money system – or, more precisely, our fiat money system – enables the constant expansion of credit. The crucial question is: How long can this system continue to function before it reaches its limits?

1. Creating money out of thin air

Under the gold standard, the money supply was tied to physical reserves. Today, things are different: Central banks and commercial banks create money through credit. A balance sheet extension, an entry in the books – and suddenly new ‘money’ exists. This is not real saving, but the creation of promises to pay. Every Euro, every Dollar, every Yen in our bank accounts has been created through new debt. Book money is no longer a covered asset, but a debt of the banking system.

2. Economic cycles

The creation of new money through the issuance of new loans leads to an unstable economy. The Austrian School has clearly described this mechanism: Artificially low interest rates generate credit binges, investments without real savings, so-called misinvestments. Sooner or later, a correction is inevitable. Often, this is postponed by reigniting the credit cycle – with even lower interest rates, even greater debt, and even more massive bailout programs.

3. The limit: Debt and inflation

How long can you pile debt on top of debt? Two limits are decisive:

Government debt: If governments simply finance every deficit with new debt, the mountain of debt continues to grow and may at some point exceed the economic power of the national economy. The markets begin to doubt: Can this country ever service its bonds? The result is rising interest rates – or the central bank steps in and buys the bonds, leading to inflation.

Inflationary limit: In principle, central banks can create an infinite amount of new money. However, the purchasing power of money declines when the amount grows faster than production. Citizens lose confidence and flee to tangible assets, precious metals or foreign currencies. The final stage is hyperinflation, as the history from Weimar to Venezuela shows.

4. The political incentive

Why stick with such a shaky system? Because it offers enormous advantages for the political elite. Debt financing allows them to hand out election gifts, wage wars and serve interest groups without the need for immediately visible tax increases. The costs only appear later, in the form of inflation and growing debt. The state lives off the ‘invisible tax’: Currency devaluation.

The system is also lucrative for banks: They earn money from lending and benefit from bailouts in times of crisis. The bill is footed by citizens and savers, whose assets lose purchasing power.

5. The trust factor

Paper money is ultimately a trust good. As long as people believe that they will be able to buy goods with their notes tomorrow, the system works. But trust can quickly evaporate. Political instability, high inflation or banking crises are enough to sow doubt. History shows that no unbacked paper money system has lasted forever. Sooner or later, it has been replaced by gold, silver or currency reform.

6. How much longer?

Forecasts are difficult. The debt money system has proven to be remarkably resilient because governments and central banks always have new tricks up their sleeves: Zero and negative interest rates, bond-buying programmes, bank bailouts, Eurobonds, joint EU debt. But every ‘rescue package’ only postpones the problem. The burdens grow, the tensions increase.

There are three conceivable end points:

1. Inflation shock: A massive loss of confidence leads to a flight of capital and a price spiral.
2. Debt haircut/currency reform: Countries declare their old debts to be unsustainable and start with ‘new money’.
3. Currency reform, for example through precious metal backing: In a breach of trust, people turn back to harder alternatives that cannot be multiplied at will.

7. Flight to tangible assets

For investors, this means that paper money is not a safe haven, but a gradually devalued promissory note. Those who want to preserve their wealth must flee to assets that cannot be multiplied at will. Gold and silver have been proven safe-haven currencies for thousands of years. Unlike government bonds, they carry no default risk, and unlike cash, they are not subject to inflationary losses. They are property, not a promise.

Conclusion

Our monetary system promotes the principle of ‘ever more debt’. It works as long as there is trust and as long as the spiral can be turned. But this logic cannot continue indefinitely. Sooner or later, debt money will reach its limits. The question is not if, but when. Those who take precautions by shifting part of their assets into real values protect themselves from the possible scenario in which banknotes are nothing more than colourful pieces of paper.