The Dismal History of Phony Money

History has shown that money – not counterfeit, but official money printed by the government – has been known to lose value and become virtually worthless. Examples include Russian rubles from pre-Revolution days, 50-million marks from 1920s Germany, and Cuban pesos from pre-Castro days. In all of these cases, jarring political and economic change destroyed currency values – suddenly, completely, and permanently.

What kinds of events could do the same thing to the U.S. dollar, and what can you do today to position yourself strategically? The potential fall of the dollar is good news if you know what steps to take today. We’re not as insulated as many Americans believe. In the 1930s, 20 percent of all U.S. banks went broke and 15 percent of life savings went up in smoke. After the emergency measures put into effect by President Franklin D. Roosevelt through the Emergency Banking Relief Act of 1933, confidence was restored with another piece of legislation: the 1933 Glass-Steagall Act. This bill created the Federal Deposit Insurance Corporation (FDIC), insuring all U.S. bank deposits against loss.

The severity of the growing situation had been seen well in advance. The financial newspaper Barron’s, established in 1921, editorialized in 1933 that: “Since early December, Washington had known that a major banking and financial crisis was probably inevitable. It was merely a question of where the first break would come and the manner of its coming.”

Two weeks earlier, the same column cautioned its readers that when the dollar begins to lose value, this leads to a series of “flights” – from property into bank deposits, then from deposits into currency, and finally from currency into gold.

We can apply these astute observations from 1933 to today’s currency situation. The government, anticipating a flight from currency into gold, had already made hoarding gold or even owning it illegal. The second step – insuring accounts in federal banks – helped to calm down the mood. By preventing the panic, currency stabilized. But in those times, we were still on the gold standard. The currency in circulation was, in fact, backed by something. Remember, that riverboat gambler who keeps asking for ever-higher markers will eventually run out of credit. At some point the casino boss realizes that his ability to repay is questionable. Maybe those markers are just a heap of IOUs that can never be cashed in.

In the 1930s, the causes of the Great Depression were complex but related to a series of obvious abuses in monetary, financial, and banking policies. History has simplified the issue by blaming the Depression on the stock market crash (which takes us back to the explanation that “wet sidewalks cause rain”). The stock market crash, one of many symptoms of policies run amok, has lessons for modern times. The unbridled printing of money – expansion of the “IOU economy” – is good news for those who recognize the potential for gold.

We hear experts on TV and in the print media shrugging off the deficit problems. “Our economy is strong and getting stronger” is the mantra of those with a vested interest in keeping dollars flowing: Wall Street brokers and analysts, for example. But we cannot ignore the facts. The federal deficit is growing by more than $40 billion per month. It is not realistic to point to this economy and say it’s doing just fine.

Gold is the beneficiary of reckless monetary policies and the War on Terror. Check the average value of an ounce of gold over the past decade. It has been rising steadily since the end of 2001. The cause of this change in gold’s price may be attributed at least partly to the attack on the World Trade Center. But it reflects equally on the Fed’s monetary policies and spiraling debt-based economic recovery. During the same period that gold prices have begun to rise, we should also take a look at the trend in money in circulation.

This is troubling for the dollar but – again – great news for gold. Remember what the world economic and political situation was like in the early 1970s: a weakening dollar, easy money, and international unrest. Sound familiar? We’re back in the same combination of circumstances that were present when gold prices went from $35 to over $800 per ounce.

The numbers prove that gold is going to be the investment of the future. World mining in gold averages 80 million ounces per year, but demand has been running at 110 million ounces. So if central banks want to hold the value of gold steady, at least 30 million ounces per year must be sold into the market. This creates a squeeze. As the dollar weakens, central banks will want to increase their holdings in gold bullion, not sell it off.

This is why gold’s price has started to rise and must continue to rise into the future. As long as that demand grows – and it will rise as the dollar’s value continues falling – the price of gold simply has to reflect the forces of supply and demand.

But, you might ask, why do central banks want to hold down the value of gold? We have to recognize how this whole money game works. Most world currencies are off the gold standard, following the U.S. example. So as gold’s value rises, it competes with each country’s currency. Of course, the trend toward weakening currencies and the continuing demand for gold mean that the growth in gold’s value could continue strongly for many years to come.

When the United States removed its currency from the gold standard, it seemed to make economic sense at the time. President Nixon saw this as the solution to a range of economic problems and, combined with wage and price freezes, printing as much money as desired looked like a good idea. Unfortunately, most of the world’s currencies followed suit. The world economy now runs primarily on a fiat money system.

Fiat money is so-called because it is not backed by any tangible asset such as gold, silver, or even seashells. The issuing government has decreed by fiat that “this money is a legal exchange medium, and it is worth what we say.” So lacking a gold backing or backing of some other precious metal, what gives the currency value? Is there a special reserve somewhere? No. Some economists have tried to explain away the problems of fiat money by pointing to the vast wealth of the United States in terms of productivity, natural resources, and land. But even if those assets are counted, they’re not liquid. They’re not part of the system of exchange. We have to deal with the fact that fiat money holds its value only as long as the people using that money continue to believe it has value – and as long as they continue to find people who will accept the currency in exchange for goods and services. The value of fiat money relies on confidence and expectation. So as we continue to increase twin deficit bubbles and as long as consumer debt keeps rising, our fiat money will eventually lose value. Gold, in comparison, has tangible value based on real market forces of supply and demand.

The short-term effect of converting from the gold standard to fiat money has been widespread prosperity. So the overall impression is that U.S. monetary policy has created and sustained this prosperity.

Why abandon the dollar when times are so good? This is where the great monetary trap is found. If we study the many economic bubbles in effect today, we know we eventually have to face up to the excesses, and that a big correction will occur. That means the dollar will fall and gold’s value will rise as a direct result.

The sad lesson of economic history will be that when the gold standard is abandoned, and when governments can print too much money, they will. That tendency is a disaster for any economic system, because excess money in circulation (too much debt, in other words) only encourages consumer behavior mirroring that policy.

Thus, we find ourselves in record-high levels of credit card debt, refinanced mortgages, and personal bankruptcies – all connected to that supposed prosperity based on printing far too much currency: the fiat system.

We can see where this overprinting will lead. As debt grows relative to gross domestic product (GDP), we would expect to see positive signs elsewhere, such as a growth in new jobs. But like a Tiananmen Square Rolex watch deal, the value simply isn’t there. Job growth is slow but, in reality, there is a decline in earnings. High paying manufacturing jobs have been replaced and exceeded by low-paying retail and health care sector jobs, so even if more people are at work, real earnings are down. Instead of simply measuring the number of jobs, an honest tracking system would also compare average wages and salaries in those jobs. Then we would be able to see what is really going on – more low-paying jobs being created, replacing high-paying jobs being lost.

Addison Wiggin
The Daily Reckoning

The Daily Reckoning