How to Understand the Monetary System

Jan262011

The reason the global monetary system survives is largely thanks to the public’s blissful ignorance of exactly how it works. To paraphrase one familiar analogy, if you knew how sausage was made, would you still eat it? It’s probably safe to say that the vast majority of the world’s citizens have no clue that the integrity of the currency they work for, save and use as a medium of exchange every day rests on nothing more tangible than their respective governments’ authority to and solemn promise to tax them in the future.

“It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

--Ford Motor Co. Founder Henry Ford

The first thing you need to understand about our modern global monetary system is that all currencies in the world today are fiat currencies, and all fiat currencies are designed to lose value.

Before Our All-Fiat Currency System

Once upon a time, the U.S. dollar and many of the other currencies now in existence derived their value from the gold stored in national treasuries. In effect, each unit of currency was a sort of IOU to the holder signifying it was backed by a like amount of gold.

As described in Michael Maloney’s book, “Guide to Investing in Gold and Silver,” before the Federal Reserve was created, each U.S. Treasury note (paper dollar) was fully backed by gold or silver. When the Federal Reserve Act was passed in 1913, the amount of gold backing each dollar was reduced to just 40% of the face value of existing currency. In effect, this allowed the U.S. government to increase the amount of currency it could create and spend by 60%, enabling deficit spending for World War I and the accompanying increase of the currency supply.

Then, in 1934, the U.S. government devalued the dollar by 41% by raising the price of gold from $20.67 per ounce, the price established in 1834, to $35 per ounce. This revaluation of the dollar raised the value of the gold held at the U.S. Treasury, so that it once again matched the total value of base money, or all the dollars then in circulation. In effect, the U.S. dollar was once again fully backed by gold. For many years, the governments of the world’s developed nations more or less cooperated under the Bretton Woods international monetary system—to keep the price of gold at $35 per ounce by selling gold into the open market.

Under the Bretton Woods system, the U.S. dollar was designated the world’s reserve currency. Most other nations pegged their currencies to the dollar, and the U.S. in return agreed to redeem U.S. dollars in gold at the rate of $35 per ounce. Under Bretton Woods, the world essentially was on the “Dollar Standard.”

But the Bretton Woods system turned out to be not up to the complexities of a modern global economy. The currency supply was once again inflated to fund WWII, Korea, Vietnam, and President Lyndon B. Johnson’s social programs. America’s foreign policy increasingly meant spending lots of dollars in other countries on foreign aid, defense and military spending and international investment and trade. As a result, lots more dollars flowed into the treasuries of other nations, and much less capital flowed back into the U.S. Treasury, resulting in imbalances.

From the 1950s on, the U.S. government and the Fed undertook a series of interventions in the free market designed to bring the U.S. monetary system back into balance. As always ultimately happens whenever authorities interfere with the workings of the free market, for every action taken, there were unintended and usually destructive consequences. Long-term interest rates kept artificially low encouraged foreign borrowing and discouraged domestic investment. To counter

French President Charles de Gaulle, who had a bone to pick with the United States, opposed the use of the dollar as the world’s reserve currency. France began buying up dollars and redeeming them in gold, seriously depleting the supply of gold in the U.S. Treasury.

As described by HistoryCentral.com:

“By the end of the 1960s, it was clear that the ills plaguing the international monetary system and the American dollar would have to be addressed at a basic level. The Kennedy and Johnson Administrations had applied solutions to the mounting balance of payments crisis that were at best patch-up jobs, postponements of the inevitable. The balance of payments was off-balance, the dollar was overvalued, inflation was picking up speed, and the United States could do little to restore economic order without compromising major aspects of domestic and foreign policy.”

In the end, the United States was not able to meet its commitment to the rest of the world under the Bretton Woods system to keep the U.S. dollar pegged to gold at the rate of $35 per ounce. The bottom line is that Bretton Woods did not allow the United States the “flexibility”—read the ability to create as much currency as it needed—to fund its foreign and domestic policy goals.

By 1971, the United States was essentially bankrupt; it did not have enough gold in the Treasury to redeem all the dollars in circulation.

That year, President Nixon severed the link between the U.S. dollar and gold. With his act, in effect, every currency in the world—thanks to the dollar’s status as the world’s reserve currency—became fiat currency.

Now, fiat currency is not backed by gold or any other tangible asset. The only thing backing fiat currency is the good faith of the people—faith that the value of the currency will be sustained by a government’s future taxing of its taxpayers. As Michael Maloney wrote in his book:

“A fiat is an arbitrary decree, order, or pronouncement given by a person, group, or body with the absolute authority to enforce it. A currency that derives its value from declaratory fiat or an authoritative order of the government is by definition a fiat currency. “

Now unencumbered by U.S. and world monetary policy, the free market bid the price of gold up until, in 1980, when gold reached $850 per ounce before falling, the value of the gold held at the U.S. Treasury exceeded the total value of base money—the total of dollars in circulation—plus all the dollars existing in the form of outstanding revolving credit.(For more information about pressures that drove gold back down, see the WealthCycles.com article, How The Hunt Brothers Capped the Price of Gold.)

At WealthCycles.com, we measure the amount of currency in circulation by adding the number of dollars in circulation and in bank reserves (base money) to the total of dollars represented by outstanding revolving credit, which is mostly in the form of unpaid credit card balances. That’s because, whenever you charge a purchase to your credit card, in effect new currency is created in the amount of your charge. That new currency stays in circulation until you pay off your credit card balance. In many ways credit cards are replacing cash as a medium of exchange and must be included in measuring the total cash, and its digital equivalent, in our modern-day monetary system.

 Shaky Foundation of Modern Monetary System

But in all likelihood, 99.9% of the world’s population doesn’t have a clue about the shaky ground on which the world’s monetary system, our fiat currency system, rests. Many people still believe that the U.S. dollar is backed up by gold sitting in a vault at Fort Knox. Most have no idea that the only thing that backs every currency in the world right now (including the U.S. dollar) is debt and the solemn promise of each government to tax its citizens in the future to pay that debt. In the United States, this promise is called a Treasury bond.

“Should government refrain from regulation (taxation), the worthlessness of the money becomes apparent and the fraud can no longer be concealed.”

 --John Maynard Keynes in Consequences of Peace

However, the overwhelming ignorance and confusion about how our monetary system works is changing. The global Financial Crisis shook things up, got people’s attention, forced many people to take a closer look. In our information society, the public is becoming educated faster, and knowledge is spreading quicker, than at any time in history. And as the information gets out there, people’s faith in all currencies, especially the U.S. dollar, will be shaken to the core.

Today we are hearing a lot about currency wars, as nations such as China continually devalue their own currencies in order to keep them low in relation to the dollar. Every country wants a weaker currency because a weaker currency helps their exports and GDP figures. By weakening their currencies, governments are able to keep the prices of their goods low, making them more attractive to foreign buyers. The United States’ devaluation of the dollar via currency creation in effect forces other nations to devalue their currencies as well. It is political death to have a strengthening national currency in a world of fiat currency debasement.

There remains a serious looming threat of national currency protectionism, with possible showdowns between western and eastern blocs. It almost looks as though the first currency regime to establish gold again as its anchor may become the world's reserve currency, as the world will flock to the stability that only gold can provide—as has happened repeatedly throughout history.

In a November 2010 article, the Economist cites Belgian economist Robert Triffin in describing the growing international conflict over monetary policy:

“Consider, for instance, the tension between emerging economies’ demand for reserves and their fear that the main reserve currency, the dollar, may lose value—a dilemma first noted in 1947 by Robert Triffin, a Belgian economist. When the world relies on a single reserve currency, Triffin argued, that currency’s home country must issue lots of assets (usually government bonds) to lubricate global commerce and meet the demand for reserves. But the more bonds it issues, the less likely it will be to honour its debts. In the end, the world’s insatiable demand for the “risk-free” reserve asset will make that asset anything but risk-free. As an illustration of the modern thirst for dollars, the IMF reckons that at the current rate of accumulation global reserves would rise from 60% of American GDP today to 200% in 2020 and nearly 700% in 2035.”

The world economy is at the brink of a deflationary spiral. Governments and central banks are taking desperate measures, flooding the global economy with currency in the form of stimulus packages, bailouts, deficit spending and cheap credit, in an effort to ward off deflation.

If the future economy is bad, if growth remains stagnant or declines, as is likely, it will become increasingly, if not impossible, to pay off the debt that backs each unit of. If you look beneath the surface, the strength of the U.S. economy and the financial position of the U.S. taxpayer look shakier than at any time in history. The official U.S. national debt today is $127,000 per taxpayer, and when you add in consumer debt, mortgage debt, and credit card debt, it brings the total to more than $500,000 in debt for each taxpayer. If you throw in the United States’ unfunded liabilities, such as Social Security and Medicare, the total comes to more than $1 million in debt per taxpayer. None of these numbers is sustainable, especially when there are 26 million people in the U.S. who are unemployed or underemployed.   

Gold’s Firm Foundation

Although we have no empirical data before the establishment of the U.S. Federal Reserve, it appears that the free market has periodically revalued gold—increasing its value to account for the excess currency in circulation—time after time, for the past 2,400 years.

The lessons of history tell us that the free market will bid up the price of gold until the value of the gold held in government treasuries is once again in equilibrium with the value of circulating currency. With a world economy more interconnected than ever before in history, and with every currency in the world now fiat, we can expect the free market to push gold prices high enough to account for all the currency now circulating in the world. If this happens, it will be nothing unusual… It will just be history repeating itself. When you look at the relationship between gold and the circulating currency media over long periods of time, they don’t just appear to be interrelated, they appear to be conjoined. Two sides of the same coin, so to speak.

Gold and silver have been rising against all national currencies since 2005. Over the long-term, inflation is inevitable, as governments and central banks implement inflationary policies such as quantitative easing and lowering the cost of debt, in order to avoid deflation. The more currency that is floating around, the higher the prices of precious metals can be expected to rise. That’s because throughout history, every time a nation has debased and finally destroyed its currency, the free market has chosen gold and silver as the ideal money.

But the massive expansion of currency supplies around the world has created conditions ripe for a currency crisis of massive proportions. Ultimately, gold will not only benefit from the massive expansion of the currency supply, but it will also benefit from the global currency crisis that lies in wait.     

During these crises, it is nearly certain that holders of precious metals will be the beneficiaries of the wealth transfer that will occur as the entire globe rushes into the safe-haven asset. The coming rush to gold and silver will be a completely different type of bull market, because not only will you get the buyers who are looking for opportunity, but you’ll also get people panicking to simply salvage some of their wealth. The monetary crisis will offer a once-in-a-lifetime opportunity that will benefit from both fear and greed at the same time.  In fact, I believe will be the greatest opportunity in history.

Gold and silver rising in value against fiat currencies is inevitable.  As Michael Maloney wrote in his book… “It is as certain as the sunrise.”

http://wealthcycles.com/features/understanding-monetary-system