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How does Paper Money (or “fiat” currency) jeopardise our economy, and ultimately our existence?

February 2, 2013 Thought Leaders, Uncategorized 3 Comments
The economy

By Daniel Jeffares ©2013 Fresh Insights

In this article, Daniel Jeffares addresses the issue of the ongoing GFC head-on in terms that are immediately and intuitively obvious to all.

Most people have a sense that all is not OK at the moment and they are resistant to taking action to address their concerns because nobody is being straight with them about the underlying dynamics of the unfolding crisis.

It is the uncertainty … that people feel about what is going on that causes this paralysis. Here Jeffares provides a straightforward explanation of the dynamics of the global financial system that have underpinned wealth accumulation for the past 40 years (being money supply inflation in particular).  As a result, people should now be in a much better position to make informed decisions about how to structure their affairs to take account of the range of alternative scenarios they face.


How does Paper Money (or “fiat” (“fiat” meaning “by decree”) currency) jeopardise our economy, and ultimately our existence?

In my 20 odd years of banking experience I’ve met only a handful of people who understand money, which is not so surprising since it’s only less than ten years ago that I really began to understand it myself.

A good place to start is with GOLD. After all, gold has been used as a medium of exchange for thousands of years.

Consider a 50 gram piece of solid gold. It’s enough to put a 1500 KW solar panel system on your roof and generate income of about $750 a year.

You could also parachute into any village on the planet and get food and lodging, or a shovel to the back of your head, depending on how friendly the natives were.

Regardless of how much it is worth, it has never been worth “nothing”.

As a matter of interest, there is only one Olympic sized swimming pool full of gold on the surface of the planet and one third of this was stolen from the Incas in the 16th century.

We’re often overwhelmed by the seemingly kaleidoscopic complexities of global finance (as discussed by bankers, economists and the like) and presume that we could never really understand it ourselves.

But the basic principles are almost absurdly simple. In fact, so simple that when the mechanisms by which money can be created from thin air are understood, it is impossible to imagine how it wasn’t obvious to us in the first place.

Indeed, the fraud that is our current paper money system is so simple as to boggle the mind.

The best illustration of how easily money can be created is in the form of a story that has come to be known as the Goldsmith’s Tale. This is a story that dates back to the 17th century at least and is a cautionary tale for any community that is convinced to rely upon paper or “fiat” currency by the central bankers of their day.

The Goldsmith’s Tale

Imagine a group of about 20-30 people in a room (including yourself).  These people represent the merchants and traders in a small town where gold bullion is the medium of exchange.

I am the town’s goldsmith and I make a living minting gold coins from bullion that can be used for the purposes of trade.

The more successful of you (the people) accumulate your profits in the form of gold coins. The more profit you make, the more you worry about being robbed at home, so you decide to deposit your bullion with me for safekeeping, for which I charge a small fee.

When you make your deposit, I provide you with a bearer’s certificate guaranteeing that you will receive your gold back upon demand – (say) one certificate (or bank note) for each ounce of gold in my care.

I’m an upright citizen with connections in high places.

Indeed, such is the level of confidence you have in my stewardship of the townsfolk’s gold that the certificates or notes on issue trade as freely as if they were real ounces of gold.

Pretty soon most of the gold bullion in existence is on deposit with me and I grow rich on the fees I’m earning to keep it safe.

I keep my wealth in gold bullion too, so it is only natural that when some of the merchants in the community want to borrow gold to finance some new venture, they come to me for a loan upon which I charge them interest.

Now, when I lend the money, I could hand over the bullion itself, but it works equally well if I simply issue a bank note that is as readily accepted in the market place.

All good so far.

I grow even richer on the interest I’m earning and pretty soon those of you with deposits want to lend your money out too.

So in return for assessing the borrower’s credentials, taking security over his property and managing the loan portfolio, we share the interest earned and everybody’s a winner.

Really!

The merchant gets his working capital upon which he turns a profit in the market, you get interest on your deposits instead of paying me a fee for storage, and I earn a margin on every dollar lent out in return for brokering the whole arrangement.

All good so far.

Except, I was lying awake last night and I had a thought. You all seem perfectly happy accepting bank notes in exchange for your gold bullion deposits. You trade these happily in the market place secure in the knowledge that you can convert them to gold on demand. You’re even happy to pay interest to borrow gold in the form of a bank note.

What if I printed up some bank notes to lend to you that didn’t have any deposit to back them?

Who would ever know?

Unless everyone wanted their deposit back at the same time, I could print a vast number of bank notes and nobody would ever be the wiser.

Now, I become really rich. Nothing beats lending money that previously didn’t exist!

Pretty soon, the market is flooded with bank notes, prices start to rise in proportion to the volume being printed and soon the townsfolk get suspicious.

The market place is atwitter.

You (the people) start to gather in the town square outside my place (which is now known as “the bank”).

The angry mob is waving banknotes in the air and demanding the return of the gold the notes represent.

Now, either you’re beaten back from the bank steps by the police wearing riot gear and firing tear gas, or you break through and find the vaults are empty and my head ends up on a stick.

The US Federal Reserve (a brief and brutally simplified history)

There are literally thousands of banks in the US and in the late 19th century, a few of them were getting a little out of hand and printing up their own currency without the gold deposits to back them.

Just like the goldsmiths of old.

Now, while their effect was localised, these bank frauds undermined community confidence in the banking system and commerce suffered.

By 1913, an altruistic group of bankers – Rothschild, Lazard, Warburg, Lehmann, Morgan, Loeb, Kuhn, Goldman and Sachs, to name a few, got together to propose a new Private Central Bank to avoid such scams taking place in the future.

US price inflation

US price inflation

(Chart of US price inflation since 1800)

This chart shows what happened next.

Despite inflation being virtually zero for the entirety of the 19th century, it started to kick off from 1913.

Initially, the printed money went almost entirely into the great stock market bubble of the 1920’s.

When credit was withdrawn in 1929, the bankers of the day foreclosed on borrowers, collected their security in the form of property and shares, and the game started over once more.

By 1933, US citizens were denied the right to convert bank notes to gold bullion and indeed were required to surrender what gold they did have in exchange for paper*.

By 1971, even foreign states were denied the right to convert their US dollar holdings to gold and the stage was set for an exponential growth in the printing of money.

 

(Youtube“Richard Nixon Gold Window” to see him announce the “temporary suspension” of the convertibility of USD to GOLD)

Now, the graph above only charts US price inflation during this period. Charting the extent to which money supply grew would require an Al Gore “scissor lift” moment. I simply cannot exaggerate the extent to which money has been printed since 1999.

In the fourth quarter of 2007 alone, money supply doubled. In the past six years the central banks of the US, Europe, Britain, Japan and China alone have printed just under USD$10 trillion.

Here is the balance sheet of the Bank of England as point of reference:

 

Bank of England

Bank of England

So, what’s the solution to the problems created by having printed such vast quantities of paper and electronic money in both the US and Europe in particular?

Yes, you guessed it, PRINT EVEN MORE.

So, where do we stand today?

  • Unfunded liabilities in the US (Medicare, pensions, infrastructure etc.) amount to perhaps $100 trillion.  The good times are over and the tax base is shrinking.
  • The European “resolution” of the sovereign debt crisis amounts to a fraud allowing the banks to pretend their Greek bonds still have some value while ignoring the inevitable defaults of Italy, Spain, Portugal and Ireland. No allowance has been made for the flow-on effects of the austerity measures on government revenues, corporate or consumer solvency. In short, the solution is an 18 month band-aid at best.
  • The inflationary consequences that would normally be associated with money printing on such a scale have been distributed worldwide and hit the poorest nations hardest with rising commodity prices barely noticed yet in the west.
  • In Australia, the inflation has been channelled into asset prices for more than 40 years with property and shares in particular subject to annual compound growth in nominal values of 10% p.a. or more, resulting in a massive redistribution of wealth to those who own or have borrowed against such assets from those who don’t.
  • Specifically, around half our domestic banks’ balance sheets have been funded with this printed cash and the majority if not all of our apparent economic growth in the past 40 years has simply been a consequence of this increasing indebtedness. During the 90’s alone, personal indebtedness doubled – new cars, granite kitchen benches, mobile phones and private schools – all on credit and people feeling ok about it as long as their superannuation and houses go up in price at the same time.
  • We have been shielded from rising commodity prices with a strong dollar and the same currency strength has enabled us to buy China’s manufactured goods at breathtakingly low prices despite the retail oligopolies gouging us for super-profits
  • In common with the US, few in Australia would ever vote to bring living standards in line with real incomes

At this point, I’ll hand the discussion over to you.  What are the implications of the unfolding crisis within the global currency system (the GCC) for property investment, retirement savings and estate planning?


Author’s Note:

The capitalism piece, “After Capitalism – then what?” by Dennis Pratt is an interesting one. I’ve been delivering the above presentation on the subject of the underlying cause of the current financial crisis for some time now.

So, there’s nothing like going back to first principles to ensure that any debate about meta-level issues (like the limitations of capitalism) are discussed within the context of a common understanding of the basic dynamics of currency – a subject with which regrettably few in the banking industry are familiar.  I trust this article will be of interest to your readers and contribute to the “After Capitalism …” discusion.

Daniel Jeffares

 


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3 comments

  1. Pingback: The National Learning Institute How does Paper Money (or "flat" currency) jeopardise our economy, and ultimately our existence? - The National Learning Institute

  2. Daniel Jeffares on said:

    How do you factor into a portfolio strategy the inevitable, continual and exponential money supply inflation to which central banks worldwide have publicly committed ?

    Or do you cross your fingers and hope the issue goes away?


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