Paper and Promise, Part I

The Daily Reckoning PRESENTS: Terms like “money” and “currency” are thrown around with abandon. If this left you a little unclear on their exact meaning, you’re not alone; hardly anyone thinks about such things these days. So before considering gold’s once and future role in the global economy, James Turk, in this excerpt from his book, The Coming Collapse of the Dollar, examines the true nature of money. Read on…

PAPER AND A PROMISE, PART I

Pick up any introductory economics text, and you’ll see money de?ned as something that performs three functions:

? A standard of value – that is, a generally agreed-upon measurement used to express the price of goods and services.

? A store of value, which holds its purchasing power over long periods of time, to allow people to save and thereby defer their spending until some future date.

? A medium of exchange, which is easily transferred from one person to another in return for goods and services.

This is an acceptable de?nition, as far as it goes. But a deeper understanding of money is possible when you think of it as a communications medium. Just as spoken language enables us to convey ideas, money is the mental tool each of us uses to communicate our own subjective view of value in an exchange. Say, for instance, that a seller offers something at a given price, which represents his (perhaps hopeful) view of its value. You counter with a lower price, and you meet somewhere in the middle, at a price you can each accept. Money is both the conceptual framework in which this conversation takes place and the tool that allows you to translate each other’s idea of value into understandable terms. Money thus makes economic calculation, and by extension our market-based economy, possible.

Just as a given word means the same thing over years and centuries, allowing language to convey ideas from one generation to the next, money communicates the measurement of wealth. A gram of gold is an unchanging unit of account, like an inch or a meter. It conveys meaningful knowledge by how much it has purchased over time. A gram of gold has bought roughly the same amount of wheat since the Middle Ages, for instance.

When a unit of account is unchanging (again, think of inches or meters, which refer to the same lengths from one year to the next), the money based on it is “sound.” That is, it effectively communicates wealth over time. As you’ll see in the next couple of chapters, for 200 years the British pound was sound because each unit of currency was, throughout this period, de?ned as 0.2354 troy ounces of gold. And the U.S. dollar was sound from 1900 to 1933 when it was de?ned as 23.22 grains of ?ne gold. These currencies were simply names for given weights of gold.

Today’s dollar, on the other hand, is emphatically not sound, because it isn’t de?ned in any unchanging way. A dollar isn’t a weight of gold, sliver, or anything else. It’s simply a bookkeeping entry, an IOU of the banks that are permitted by the U.S. government to create dollars. Compare the following chart to the one on the preceding page for an idea of the difference between sound and unsound money.

But sound money is not the same thing as stable purchasing power. As the gold/oil chart illustrates, over the years an ounce of gold has bought very different amounts of oil. Why? Because supply and demand for both goods and money are always in ?ux, causing prices to bounce around. The difference is that with sound money the ?uctuations tend to

even out over time, bringing the price back into line with historical norms. The purchasing power of unsound money tends to move in only one direction: down.

Currency, meanwhile, is the physical representation of money, the item that passes from hand to hand in return for goods and services. When it takes the form of society’s standard of value, as with gold and silver coins (or, as you’ll learn shortly, older forms of money like goats and slaves), currency is also money. When it takes the form of, say, paper notes, currency is not money but a “money substitute.” And if a currency is not de?ned in terms of money, but is created and controlled by a national government, it is a “?at” currency, so called because it exists by government ?at, or decree.

In accounting terms, money is a tangible asset, while a money substitute is a liability of a bank, the assets of which may or may not be money. In practical terms, only money can extinguish an exchange for some good or service. That is, an exchange is extinguished when assets are exchanged for assets. If you accept a money substitute (for instance, dollars) when you sell a product, the exchange is not extinguished until you use those money substitutes (those dollars) to purchase some other good or service.

Why does gold – or any other successful money – hold its value? Not because it has “intrinsic” worth. Given its other uses in today’s economy, mainly jewelry and a few electronics niches, gold as a purely industrial commodity would be worth far less than indispensable substances like oil or wheat. But gold isn’t an industrial commodity. It is money, which is accumulated, not consumed like other commodities. As such, its value depends on our belief in its ability to function as money. We trust sound money because it exists in limited supply and is, by definition, not subject to government manipulation.

Fiat currencies, in contrast, are controlled by governments, which are, as you now know, fundamentally incapable of managing their monetary affairs.

Keep these distinctions in mind; they’re key to the unfolding drama of the dollar and gold.

Over the centuries, humanity has auditioned an amazing variety of things for the role of money. The ancient Egyptians used barley; Tibetans used bricks of pressed tea leaves (pieces of which were cut off to make change); Solomon Islanders used arm rings made from the shells of giant clams. And just about every society, at some point in its development, has used livestock as a medium of exchange. Goats, camels, human slaves – you name it, we’ve tried it.

But virtually all early forms of money were imperfect choices, for fairly obvious reasons. Seashells are fragile, and their supply tends to surge after a good storm. Tea varies in supply with the quality of the harvest. Goats and slaves aren’t interchangeable, don’t hold their value over time, and, ahem, resist being divided up for change. So after much trial and error, most societies settled on pieces of metal as their money. More durable than goats and less variable than tea, metals like bronze, copper, silver, and gold could be mined, smelted, and turned into recognizable, more or less identical coins that could then be traded and stored. Bronze and copper, being more common and less attractive, became small change, while silver generally took the midrange and rare, beautiful gold became the most prized of all.

The ?rst true gold coins appeared in Lydia, now part of present-day Turkey, around 600 B.C., and over the ensuing centuries, minting techniques were re?ned by the Greeks, Persians, and Romans (who, as you read in Chapter 2, designed and debased many different coins).

Once established as humanity’s money of choice, gold came to be synonymous with wealth and power, and as Europe emerged from the Dark Ages and began to look outward, the search for new gold supplies became a key driver of modern history. Sixteenth-century “conquistadors” like Hernando Cort?s and Francisco Pizarro led invasions of the New World in search of fabled cities of gold, destroying indigenous cultures in the process and paving the way for the colonization of the Americas. Three centuries later, in 1848, a handful of gold nuggets turned up on a Sacramento farm, igniting the California Gold Rush. Half a million people ?ooded the sparsely populated U.S. West in less than a decade, launching a migration that continued throughout most of the twentieth century.

Eventually, however, the imperfections of gold and silver money became a problem. Metal coins were too noisy and bulky to be practical in large denominations. They also wore out over time, eroding a small but signi?cant part of an economy’s wealth. So in the 1690s, the founders of the Bank of England – destined to become the world’s dominant bank over the next two centuries – had an epiphany: Instead of letting gold and silver coins circulate, why not lock them in a vault and issue paper notes to be used in the coins’ place? The bank began issuing paper “pounds” with the promise that they could be redeemed at any time for pound coins composed of gold or silver. Convertibility, so went this radical new theory, would make paper acceptable by eliminating questions about its true value.

The result was a conceptual breakthrough: the ?rst widely circulated money substitute. Where money (de?ned as a standard and store of value) and currency (a medium of exchange) had previously been one and the same, a tangible asset, now they were separate things. Soon, much of England’s money, in the form of gold and silver, sat in the Bank of England’s vault, while its currency, now a liability (or IOU) of the Bank, circulated as bits of paper.

The honeymoon lasted for about three years, during which time the citizenry was happy to carry around light, quiet pound notes. But it soon became clear – in a process destined to be repeated many times in later centuries – that the monetary authorities were issuing more paper than was backed by the gold and silver in their vaults. In one of history’s ?rst bank runs, holders of pounds rushed to convert paper into metal, and the system careened toward failure. In desperation, King William III appointed his resident genius, Sir Isaac Newton, Master of the Mint in 1699. True to form, Sir Isaac got to the essence of the matter: He recognized that paper currency was an important innovation, but also that it wasn’t money. Putting bureaucrats in charge of the printing presses would therefore lead to disaster.

To be viable, paper currency needed an external standard by which it could be measured and controlled. So Newton de?ned the pound as a precise weight of gold and linked the amount of paper money outstanding to the weight of gold in the Bank of England’s vault (in the process dislodging silver, which until that time had been England’s dominant form of money). Paper currency circulated as a substitute for money (i.e., gold), while gold provided the standard by which the value of paper currency was measured. Linking gold to bank-issued currency came to be known as the classical gold standard. And notwithstanding the occasional war-related interruption, it would serve the British Empire well for two centuries.

More to come tomorrow…

Regards,

James Turk
for The Daily Reckoning
October 17, 2006

Editor’s Note: James Turk has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics.

He is the author of two books and several monographs and articles on money and banking. He is the co-author of “The Coming Collapse of the Dollar” (Doubleday, December 2004).

In addition, James Turk is the Founder and Chairman of GoldMoney.com. Since 2001, thousands of individuals and companies have used GoldMoney® to buy gold to protect their wealth from today’s financial uncertainties. Many of them have also found GoldMoney’s patented process of digital gold currency payments to be an ideal payment solution for online commerce.

Learn more about GoldMoney®.

“The surest way to ruin a man who doesn’t know how to handle money is to give him some.”

-George Bernard Shaw

Approximately two weeks ago, a group of regulatory agencies voiced their concern about what have become standard practices in the mortgage business. They released what amounted to a new set of standards, in a report entitled “Interagency Guidance on Nontraditional Mortgage Product Risks.”

And now, cometh the Comptroller of the Currency, John C. Dugan, speaking about the innovations of the mortgage industry:

“Lenders who originate these types of loans should follow sound underwriting practices that consider the borrower’s repayment capacity.”

Traditionally, the lender judged both his man and his market. If both were deemed solid, he would take a chance, lending the man a mortgage and hoping that the market was strong enough to allow him to recover his money if the man failed.

Nontraditionally, however, lenders wouldn’t even bother with the man; instead, they would judge the market…and judge it foolproof. As long as house prices were rising at double-digit annual rates, non-traditional lenders considered mortgage lending a ‘can’t lose’ enterprise; any fool could do it.

They were right. It was a no-brainer, in the sense that anyone with any brain at all would have avoided the new products. From reading the newspaper, we learned about the number and variety of non-traditional mortgages that flourished in the last six years. Adjustable rates, of course, became common. But so did mortgages with zero-down payments, alluringly low starter rates…including interest-only mortgages, flexible payments, and ‘stated income’ applications…in which the borrower is left to use his own imagination in describing his financial circumstances.

From Grant’s Interest Rate Observer, we learn also that as recently as 2000, only 25% of sub-prime mortgages were of the ‘stated income’ variety. Only one percent consisted of ‘piggyback loans’ – junior mortgages designed to eliminate the need for a real down payment. And none were I.O., or interest only.

Today, 44% of sub-prime loans have ‘limited documentation,’ 31% are piggyback loans, and 22% are I.O. And now that rising housing prices are no longer a sure bet, lenders are becoming more careful. They’re beginning to do on their own, precisely what the feds are encouraging; that is, they’re beginning to ask if the customer can really pay for what he is trying to buy.

Daily Reckoning readers will chuckle to themselves recalling that the stated purpose of both the federal government’s housing policy and that of the lenders themselves was to ‘help Americans buy their own homes’ or words to that effect. Easy credit was meant to increase homeownership; renting was seen as a social disease awaiting a cure.

But the effect of ‘EZ credit’ was to turn Americans into a race of housing speculators, not of homeowners. At the margin – where renters were enticed to become homeowners – people did not actually buy houses…they merely paid for an option to buy them in the future. That’s what an interest-only mortgage actually is, and as the I.O.’s, limited doc, flexible payment ARMs reached farther and farther into the general population of homeowners, fewer and fewer people really owned their homes at all. More and more of them became gamblers, betting that property values would rise fast enough for them to keep on refinancing until they actually pulled in enough to afford to pay the principal down.

Meanwhile, we will all get an even bigger chuckle when we consider that the gullibility of the poor, sub-prime borrowers is at least matched by the gullibility of the great, super-prime lenders. Cheap suits, expensive suits – when you got down to it, they all fell for the same line of guff.

While the marginally lumped idiots took out ARMs, the hedge fund, pension fund, and insurance fund geniuses bought MBSs, mortgage-backed securities. The securities were backed by the mortgages, which were in turn backed by the imaginary incomes of the borrowers. Thus, the credit agencies rightly judged the quality of the mortgages as less than perfect, BBB. And then with the miraculous powers of modern finance, these same mortgages were put into MBSs and turned into triple-A credits!

This particular feat is attributed to the fact that the sliced and diced processed mortgages – the Spam of the lending industry – are less risky than the individual cuts. While this may be true for an individual ‘can’ of the stuff, it certainly cannot be true for the whole lot of it. The grease and fat that went in has to come out somewhere. In other words, one MBS buyer might get lucky, but they can’t all do better than average. We don’t know, but we suspect that when the tins are finally opened, the glop inside will not be very appealing.

More news:

———————

Greg Guenthner, reporting from Charm City…

“…Finding new sources of crude oil and natural gas is essential in today’s energy climate. According to some long-term industry analysis, it will be difficult to meet the higher level of demand…”

For the rest of this story, and for more market insights, see today’s issue of The Sleuth

———————

And more views:

*** A note from our small-cap superstar, James Boric:

“The world’s water supplies are in dire straits. Severe water shortages currently affect 400 million people all over the globe. That number is predicted to swell to 4 billion people by 2050. And if you think these shortages will only affect places like Africa, India and China, think again.

“Southwestern states like Arizona will face severe fresh water shortages by 2025. And as my colleague Dan Denning reported a year ag

“‘In mid-December, the premiers of Quebec and Ontario, along with the governors of eight U.S. states, signed a pact that will ban all large-scale water diversions from the Great Lakes basin. That will prevent fully 20% of the total fresh surface water of the Earth being exported by pipeline to thirsty states like California, Arizona or Nevada. The eight states that border the Great Lakes – Illinois, Indiana, Michigan, Minnesota, New York, Ohio, Pennsylvania and Wisconsin – have seen the future. And the future is that fresh surface water is going to be more and more valuable as it gets more and more scarce.’

“There is literally a war for fresh water going on all over the world. Right now, the war is being hashed out in offices and treatment facilities. But I wouldn’t be surprised if it turns violent as our scarcest resource becomes even more scarce. Those who lose will either have to move…or face death. And those who win will survive and prosper.”

*** “Better late than never,” the regulators must be thinking. Nontraditional mortgages are becoming less attractive without guidance from the feds.

The number of ARMs and I.O.s is falling sharply. Across the country, one of the nation’s leading mortgage lenders says its Option-ARM originations have fallen 23% from last year. Other lenders say their non-traditional loan business has been cut in half.

The feds may be late to the party, but at least they’ll get in the group photo at the end. And there, in the background, viewers will see housing falling down.

From MarketWatch:

“On Monday, the president of the San Francisco Federal Reserve Bank, Janet Yellen, said, ‘The housing slowdown has turned some parts of the Phoenix and Las Vegas metropolitan areas into ‘ghost towns,’ where many unsold homes stand empty.”

“Yellen went on to say that she heard this ominous description from a ‘major home builder,’ who told her that the share of unsold homes in some subdivisions around the two Southwestern cities has topped 80 percent.

“‘Though the situation isn’t that bad everywhere, a significant buildup of home inventory implies that permits and (housing) starts may continue to fall, and the market may not recover for several years,’ she warned.”

*** “In a reversal of fortune,” begins a caption in today’s International Herald Tribune, “U.S. college graduates, like these Americans at an Infosys training session, are going to India to get technology jobs.”

Well, howdya like that? America really is losing market shares to Asia. But how fast? How far? We don’t know.

In early 2005 – almost 2 years ago – the New York Times said that January’s trade deficit – a record $58.3 billion – “exceeded everyone’s worst expectations.” Just last month, yet another milestone was hit…a new record $10 billion per month higher.

Month after month, the empire’s lifeblood seeps away. Not that we care. We don’t even like the empire. We liked the old republic of decent people minding their own business.

But the decline of a great empire rarely happens without a lot of pain and turmoil. For the moment, Americans are able to sell weapons, borrow money, and get jobs in India. Later, maybe they’ll be able to sell their kidneys to the Chinese.

*** On the other hand, the number of Americans is increasing – to 300 million. While Europeans suffer fertility rates as low as 1.28 births per woman in Italy and Spain, America’s super moms put out 2.1 each. Why do Americans have so many children? No one knows. Maybe it is because they are more religious…more positive about the future…less careful…or simply because they live in such a big, empty country.

In the 1960s, the opinion mongers were all convinced that overpopulation would be the death of us all. Scientists worked on solutions, from forced sterilization in India, to putting ‘fertility control agents’ in the drinking water. In these efforts they were often aided by money from the World Bank, then doing for banking what it had previously done for Vietnam.

Now, it’s ‘the more the merrier.’ India is running out of engineers. China is running out of factory workers. Italy and Spain are running out of taxpayers.

But in America, the population continues to expand, thanks to higher fertility rates and immigration. But are more Americans really better? Yes, maybe, if you’re looking for a kidney…but not if you’re looking for a parking place.

*** And finally, granite countertops!

We don’t know how we survived this long without them. But finally, after all these years, your editor is about to have granite countertops in his own kitchen. Elizabeth is remodeling the kitchen in our new apartment. She’s promised us granite countertops. Surely, this must mark the peak of the granite countertop craze…within six months, they will be as passé as saying grace before dinner.

The Daily Reckoning