The failings in our monetary system and why it will fail again

After years of benchmark inflation (2%), financial markets across the world were in for a surprise in 2021-2022 as inflation started to surge. As a result, central banks started increasing their interest rates and financial markets experienced a downturn. Now in 2024, major central banks have started loosening their monetary policy with the Federal Reserve (Fed) cutting their interest rates yesterday by 25 basis points, bringing its rate to 4.75%. 

As we move towards the end of this monetary cycle, various central bankers have remunerated that this was an isolated incident and that the correct monetary policies are in place. However, increasingly more people understand that this isn’t an isolated incident but a product of a systematically broken system and that something has to change to break this cycle. Let’s dive deeper into the nature of inflation, the system we have created that allows this, and how you should protect yourself against it. 

What is inflation and what causes it?

Inflation is an increase in the price of goods and services or a decrease in the value of money. This is caused by a variety of factors which fall into three categories: demand-pull, cost-push, and built-in inflation. 

Demand-pull inflation occurs when the overall demand for goods and services in an economy exceeds the available supply. Cost-push inflation occurs when the cost of production rises, leading producers to raise prices to maintain profit margins. Built-in inflation is a cycle where workers demand higher wages to keep up with rising living costs, and businesses increase prices to cover higher wage expenses. However, other factors also include monetary supply expansion and government fiscal policies.

In contrast, deflation is the general decline in the price level of goods and services, increasing purchasing power as prices drop. Although this might seem advantageous, deflation can reduce consumer spending, lower production, and lead to economic slowdowns, as people delay purchases expecting further price drops. Often occurring during economic recessions, deflation can be triggered by reduced demand, increased productivity, or decreased money supply. Most economists see moderate inflation as preferable to avoid deflation's cycle of falling wages, reduced spending, and rising debt burdens.

For this reason, our monetary system is broken as we will see how this reasoning affects our everyday lives and if you don’t protect yourself correctly, it will hurt you in the long run. 

Democratically elected leaders tend to choose inflationary policies

One reason why our monetary policy is failing lies with our governments. Most of the world lives in a democracy in which we can democratically elect our leaders. Most leaders aim to lead the government for longer periods and are therefore dependent on an election cycle and this hurts the fiscal policy of a government. Why? No government wants to implement austerity measures as this weakens economic growth and makes the ruling party unpopular. So time and time again, democratically elected officials tend to adopt inflationary policies and run a deficit, which can increase aggregate demand, potentially leading to inflation if supply doesn’t keep pace. 

When examining the fiscal budgets of many countries, especially Western ones as illustrated below, it’s clear that most run large deficits. These deficits lead to higher interest payments, which in turn increases national debt. Some nations manage to "escape" this debt cycle by growing their economies faster than their debt and interest obligations, thus lowering their debt-to-GDP ratio. However, this doesn’t fully resolve the issue, as governments continue to borrow heavily, with central banks increasingly acting as lenders over the past few decades.

Monetary policy and fiscal policy have become integrated with quantitative easing

Central banks were initially established to maintain price stability within their respective economies, primarily using tools like issuing new money to stimulate economic growth or raising interest rates to cool down an overheating economy. Originally part of government structures, central banks were later made "independent" to prevent political influence over monetary policy; however, their independence remains debatable. For instance, the President appoints the head of the U.S. Federal Reserve, currently Jerome Powell, and the European Central Bank’s Executive Board is selected by the European Council—politics influence both decisions. This overlap is notable in a capitalist system where economic and political power are often intertwined.

In Europe, the political aspect has uniquely impacted the European Central Bank (ECB). Following the 2008 financial crisis, Europe faced the European Sovereign Debt Crisis, during which several countries struggled with failing financial institutions, mounting government debt, and soaring bond yields. The crisis was eventually mitigated through collective financial guarantees by European nations aiming to protect the euro, along with support from the International Monetary Fund (IMF).

In Europe, the ECB increasingly focuses less on inflation and more on the risk of a potential euro break-up, leading to blurred lines between monetary and fiscal policy. Typically, governments rely on financial markets to purchase their bonds, with the bond market acting as a gauge for economic health and inflation. In a healthy bond market, governments running large deficits or debt without a clear repayment strategy would struggle to sell their bonds or face higher interest rates. However, with the ECB working to stabilize the eurozone—and, by extension, the EU—alongside the Federal Reserve's efforts to protect financial markets, both central banks have become lenders of last resort. This intervention distorts financial markets, allowing countries to sustain ongoing deficits.

Failure of central banks to recognize their mistakes

As inflationary policies are preferably chosen in our economies in the face of possible deflation, was it surprising that inflation took off at the end of 2021? First of all, it seemed that inflation had been “tamed” as most Western countries didn’t experience any massive fluctuations in inflation as most central banks became independent in the 70’s and 80’s. This may have given these central bankers the confidence that inflation was tamed and a relic of the past. Thanks to economic models and data-driven analysis central banks will see inflation from miles away and adjust their course to achieve price stability. 

As inflation began to rise, central banks worldwide looked for explanations: first attributing it to China’s lockdowns, the Ukraine war, and supply chain disruptions; then to corporate greed and, in the ECB’s case, even to global warming. One widely echoed assurance was that “inflation is transitory.” While many of these factors contributed to inflation, central banks overlooked a crucial cause: the massive credit expansion during the COVID-19 crisis, with the US M2 annual money supply increasing from 6.8% at the beginning of 2020 to 20% in May, and peaking at 26.8% in February 2022. While expanding credit during the crisis was reasonable, both banks continued this policy as the economy reopened, which, combined with a post-lockdown surge in consumer spending, added even more fuel to inflationary pressures. Key warning signs, however, were largely ignored.

Why this cycle will repeat itself?

In today’s economic landscape, governments and central banks tend to favor inflationary policies, as deflation can lead to significant financial distress characterized by falling wages, reduced spending, and increasing debt burdens. Consequently, governments will likely pursue inflationary strategies through loose fiscal policies, while central banks often monetize this debt through quantitative easing. Unfortunately, this means that the issues surrounding inflation and our current monetary policy are unlikely to change anytime soon.

How to protect yourself?

If we look back through history, we see that several leading superpowers have encountered similar challenges. First, these nations experience strong economic growth and increased productivity, which leads to capital surpluses. This capital is then invested in education, infrastructure, and military power. When managed effectively, other countries begin to borrow this nation’s currency and use it in global markets, establishing it as a world reserve currency. However, again and again, we observe that these nations reach a peak and then begin to expand more slowly. Eventually, they need to borrow capital to close the resulting deficits, which works initially, but ultimately, the debt and interest start to accumulate, creating significant financial strain.

Unfortunately, there are only two main options for resolving this situation: one option is to default on the debt, which would trigger economic contagion, as one country’s debt is another's income. This causes other countries to offload the debt rapidly, leading to currency devaluation. The second option is to deliberately devalue the currency, making debt repayment easier; however, this undermines global confidence and often signals the beginning of a currency's decline. We have seen this pattern with the Dutch guilder, the British pound, and potentially now with the US dollar and the euro—although the euro is not a reserve currency, it is widely used in financial markets. History shows that fiat currencies tend to fail (devalue) over the long term as nations create debt to fuel economic growth.

To protect yourself against monetary debasement, we believe that you should invest in assets with a deflationary nature, such as gold and digital gold “Bitcoin”. In times of uncertainty and infinite debt creation, you need to find assets that are finite and scarce. These assets become a safe haven for capital as the strains of our system break, allowing you to be protected against losing purchasing power. Although Bitcoin still needs to prove itself when the time comes, we do believe that Bitcoin protects you against monetary debasement. You can read more about Bitcoin and the digital assets industry in our free brochure and what it can do for you and your portfolio. The choice is yours but remember, the system hasn’t changed over the past 400 years and will continue to exist.

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