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The Failure of Fiat Currencies

-- Posted Tuesday, 21 May 2013 | | Disqus


Fiat currencies are paper monies issued andcirculated by government legislation and decreed as a country’s legal tender tofunction as a medium of exchange for all transactions of goods and serviceswithin its economy.  Only the federalgovernment has the power and the authority to issue currency notes fordistribution throughout the nation.  Fiatcurrencies, such as those currently in circulation within the world’s majoreconomies, such as the United States (Dollar), the United Kingdom (Pound),Japan (Yen), China (Yuan/Renminbi) and the European Union (Euro) are ‘promises to pay’, backed solely by ‘the full faith and credit’ of theissuing country, or countries.  They arebased upon an elastic and constantly expanding money supply, as compared to acommodity system where the currency is backed by a definitive supply ofgold.  Over the centuries, all papermoney systems have eventually collapsed amid economic chaos, or, reverted to acommodity based system in order to avert economic disaster.  In this Economic Winter, we will argue thatthe current monetary policies of some of the world’s central banks – led by theU.S. Federal Reserve – are misguided by employing extensive quantitative easing(money printing) programs and facilitating an inexorable rising trend inoutstanding global debt. 

TheNext Global Financial Crisis  

In the most recent issue of Grant’s Interest Rate Observer, publisher James Grant warns: “Tumbling commodity prices over recent weeksare a warning sign to investors that China’s economic miracle is actually agross manipulation of markets that eventually have a nasty ripple effect acrossthe world.  Something has changed andmore significantly, people have noticed the change.  The world’s major central banks have beendistorting the true price of assets, such as stocks and commodities, bysuppressing interest rates and printing trillions of dollars’ worth of currencyin an effort to stimulate demand.  Suchpolicies by the People’s Bank of China will prove particularly harmful giventhat they are layered on top of the central planning policies of the CommunistParty.  Efforts by the U.S. FederalReserve and other central banks to jump-start demand have failed.  Each new dollar or yuan added to the economyis having less and less of a stimulus effect and is instead further inflating assetand consumer credit bubbles.  As China’seconomy continues to slow, commodity prices will decline further and it’spossible that China will even slip into a recession.  Today, financial crises arrive faster andmore furiously.  While it took 25 yearsfor stocks o rebound from the Great Depression in the 1930s, it took only fouryears for stock markets to recover from the financial crisis of 2009.  The accelerated cycles are the result ofdistorting policies and they leave governments and markets more accidentprone.  Investors should respond bykeeping large amounts of cash, looking for buying opportunities in depressedsectors … Keep in mind that the price of gold is the reciprocal of the world’sfaith in management of the world’s central banks.  Accordingly, investors should own some gold.”      

JohnLaw: The Father of Paper Money

As a young Scottish financier, John Law wasbrilliant, daring and unusually ambitious. For killing a man in a duel over a woman he was forced to flee toAmsterdam in 1695, where he became a close student of Dutch trade and bankingpractices; then the most advanced in the world. Eventually, he sought out opportunity in Paris, where he soon becameknown to many of the foremost figures of French finance.  Capitalizing on the weak and vulnerableFrench economy, he was able to persuade Philippe II, duc d’Orleans, Regent forthe child King Louis XV, to support his extraordinary scheme for issuingunsecured paper money.  Under his fiatcurrency system, anyone could get rich quickly, including Law and the Regent,who did.  Law founded his own royal bankand soon controlled all of France’s improving finances.  To bolster the resulting orgy of uncurbedspeculation, Law advertised the fabled riches to be found in the Frenchcolonies of the Mississippi Valley, particularly Louisiana, described as a landfilled with mountains of gold and silver, plus precious gems to be plucked fromthe river’s shoreline.  In 1720, the ‘Mississippi Bubble’ burst, ruiningthousands of investors.  Law’s wholemonetary system quickly collapsed, so he fled to Venice. 

TheFrench Assignat

While France had been deceived by John Law and hiscurrency magic, it didn’t learn from the lesson.  In his book, The Demise of the Dollar, authorAddison Wiggin recounts: By 1791, France was ready to try paper currencyagain.  The government, in ananti-aristocracy mode, confiscated property and other assets from the wealthyin exchange for assignats, noteswhich paid interest and operated like land mortgage notes.  Far from solving the problem of economicdisparity among the classes, the extreme measures only made matters worse.  Within four years, inflation had risen by13,000 per cent.  Few instruments havedeclined to zero value as quickly as the assignats. 

In a foreword to a book about the historicalimplications of French monetary policy, John Mackay described France’s attemptsat a fiat money system as: “the mostgigantic attempt ever made in the history of the world by a government tocreate an inconvertible currency and to maintain its circulation at variouslevels of value.  It also records what isperhaps the greatest of all government efforts … to enact and enforce a legallimit of commodity prices.  Every fetterthat could hinder the will, or thwart the wisdom of democracy had beenshattered …But the attempts failed.  Theyleft behind them a legacy of moral and material desolation and woe.”      

Parallelsto the 1930’s   

Within the current global economy, we can perceive agrowing threat in the challenges facing the European Monetary Union.  Not only, are there ongoing structuralproblems in several southern peripheral countries, but also, harsh austeritymeasures have exacerbated the currency bloc’s daunting sovereign debtproblem.  As was the case in the early1930’s, when Austria’s Kredit Anstalt Bank failed causing a domino effectthrough Germany, Great Britain, Japan and which culminated with the UnitedStates abandoning the gold exchange standard in 1933.  Confidence had been lost in the bankingsystem and in paper currencies to the point where thousands of U.S. banksfailed and the populace sought to protect themselves by purchasing gold and theshares of gold mining companies.  Sinceno country trusted another’s currency, world trade collapsed, extension ofcredit was curtailed and the world’s economies imploded into the GreatDepression; sending the unemployment rate to 25% in the United States.  In Europe today, we are already witnessingsimilar unemployment levels in Greece and Spain with the European Union experiencingyet another economic downturn.  In theUnited States, nearly 50 million citizens are receiving food stamps while theofficial unemployment rate hovers close to 7%.  




Spider Chart taken from:  TheWorld in Depression 1929 - 1939, Charles P. Kindleberger, University ofCalifornia Press, 1986. P. 170


XiJinping and the Chinese Dream        

As reported in the most recent issue of The Economist, China has made anextraordinary journey along the road back to greatness.  Hundreds of millions have lifted themselvesout of poverty, hundreds of millions more have joined the new middleclass.  China is on the verge ofreclaiming what it sees as its rightful position in the world.  China’s global influence is expanding andwithin a decade its economy is expected to overtake America’s.  In his first weeks in power, the CommunistParty’s new general secretary and military commander-in-chief , Xi Jinping, hasevoked that rise with a new slogan which he is using – as belief in Marxismdies – to unite an increasingly diverse nation. He calls his new doctrine the ‘Chinesedream’ which seems more designedto inspire than to inform.  It is nocoincidence that Mr. Jinping’s first mention of his dream of ‘the great revival of the Chinese nation’occurred in November during a speech at the national museum in TiananmenSquare, where an exhibition named ‘Roadto Revival’ displays China’s suffering at the hands of colonial powers andits rescue by the Communist Party.  OnNovember 15th. Mr. Jinping mentioned ‘abetter environment’ toward the end of a list of what he said were thepublic’s wishes.  Better education andmore stable jobs topped the list.  InMarch, the Chinese dream was the main subject of his acceptance speech to theNational People’s Congress – China’s parliament – on being appointed statepresident.  In early April, at an annualforum attended by foreign political and business leaders on the tropical islandof Hainan, Mr. Jinping predicted that the Chinese dream would be fulfilled bythe middle of the century. 

 In 1820, assome historians calculate and Chinese commentators like to highlight, China’sGDP was one-third of the world’s total. Then the reversals of the century of humiliation brought it low.  By the 1960’s, China’s gross domestic producthad declined to just 4% of the world total. Now, it has recovered to about one-sixth of the world’s GDP – and atleast 90% of America’s – in purchasing power parity terms, according to theConference Board, a business research organization.  Nationalists eagerly await the day whenChina’s economy becomes once more the biggest in the world by any measure; aday which many observers expect to dawn while Mr. Jinping is still leader.    

It is a well-established fact that the gold miningbusiness is very productive in China, however, none of China’s gold productionever leaves the country.  Moreover, it isa well-known fact that China has been and continues to be a major buyer of goldbullion, especially on price corrections and in secret agreements withAustralian gold producers.  How much goldChina has amassed in recent years is unknown, but it is believed to besubstantial.  At Longwave Analytics, wesuspect it is Chinese policy to ultimately initiate a gold-based currencysystem with the renminbi replacing the U.S. dollar as the world’s reservecurrency.  In Table A below, we discoverthat 37% of the increase in imports over the last 12 months into China is dueto the massive amount of gold being imported. Gross imports increased by $82 billion (U.S.), but $32 billion (U.S.) ofthis increase were from gold imports alone.        


TheReturn to Sound Money

In his 1952 book, The Theory of Money and Credit, author Ludwig von Mises expounds:The people of all countries agree that the present state of monetary affairs isunsatisfactory and that a change is highly desirable.  However, ideas about the kind of reformneeded and about the goal to be aimed at, differ widely.  There is some confused talk about stabilityand about a standard which is neither inflationary nor deflationary.  The vagueness of the terms employed obscuresthe fact that people are still committed to the spurious and self-contradictorydoctrines whose very application has created the present monetary chaos.  The destruction of the monetary order was theresult of deliberate actions on the part of various governments.  The government-controlled central banks andin the United States, the government-controlled Federal Reserve System were theinstruments applied in this process of disorganization and demolition.  Yet without exception, all drafts for animprovement in currency systems assign to the governments unrestrictedsupremacy in matters of currency and design fantastic images ofsuper-privileged super-banks.  Even themanifest futility of the International Monetary Fund does not deter authorsfrom indulging in dreams about a world bank fertilizing mankind with floods ofcheap credit.  The inanity of all theseplans is not accidental.  It is thelogical outcome of the social philosophy of their authors.

Money is the commonly-used medium of exchange.  It is a market phenomenon.  Its sphere is that of business transacted byindividuals, or groups of individuals within a society based upon privateownership of the means of production and the division of labour.  This mode of economic organization – themarket economy or capitalism – is at present, unanimously condemned bygovernments and political parties. Educational institutions, from governments down to kinder-gartens, thepress, the radio, the legitimate theatre as well as the screen and publishingfirms, are almost completely dominated by people in whose opinion capitalismappears as the most ghastly of all evils. The goal of their policies is to substitute ‘planning’ for the alleged plan-starved market economy.  The term ‘planning’as they use it means, of course, central planning by the authorities, enforcedby the police power.  It implies thenullification of each citizen’s right to plan his own life.  It converts the individual citizens into merepawns in the schemes of the planning board, whether it is called Politburo, Reichswirtschaftsministerium,or some other name.  Planning does notdiffer from the social system that Marx advocated under the name of socialismand communism.  It transfers control ofall production activities to the government and thus eliminates the marketaltogether.  Where there is no market,there is no money either.  Although thepresent trend of economic policies leads towards socialism, the United Statesand some other countries have still preserved the characteristic features ofthe market economy.  Up until now, thechampions of government control of business have not yet succeeded in attainingtheir ultimate goal. 

The Fair Deal Party has maintained that it is theduty of the government to determine what prices, wage rates and profits arefair … and then to enforce its rulings by police power and the courts.  Furthermore, it maintains that it is afunction of the government to keep the rate of interest at a fair value bymeans of credit expansion.  Finally, iturges a system of taxation which aims at the equalization of incomes andwealth.  Full application of either thefirst or the last of these principles would by itself consummate theestablishment of socialism.  However,things have not yet moved so far in this country.  The resistance of the advocates of economicfreedom has not yet been broken entirely. There is still an opposition which has prevented the permanentestablishment of direct control of all prices and wages and the totalconfiscation of all incomes above a height considered fair by those whoseincome is lower.  In the countries onthis side of the iron curtain, the battle between the friends and foes oftotalitarian all-around planning is still undecided.  In this great conflict, the advocates ofpublic control cannot do without inflation. They need it in order to finance their policy of reckless spending andof lavishly subsidizing and bribing the voters.”   


The world monetary system failed during the third LongwaveWinter in 1933.  Eighty years later, theglobal fiat monetary system is in grave danger of collapsing led by the centralbank monetary policies of the U.S. Federal Reserve, the Bank of England, theBank of Japan, the Bank of China and the stated intentions of the EuropeanCentral Bank.  The Federal Reserve continuesto implement its quantitative easing program of $85 billion (U.S.) monthlypurchases of U.S. Treasurys and sub-prime mortgage securities, with the Fed’sbalance sheet approaching $3 trillion (U.S.). It is our view that Ben Bernanke will not seek another term as FedChairman when his current tenure ends next January.  Accordingly, the current money printingprogram is likely to continue for another seven months, modified perhaps, butstill intact.  The Fed’s exit strategy fromthis initiative has yet to be determined, let alone made public.  Will the Fed ultimately reduce its holdingsvia sales in the open/secondary market, or will it simply allow its range ofholdings to mature?                                                                               

Meetings in Washington are scheduled to commencetoday to deal with the possible reinstatement of the U.S. statutory debt limit,which was suspended by the Congress in January at $16.4 trillion (U.S.).  Since the national funded debt level now approximates$17 trillion (U.S.), the debt ceiling should be reset at about $18 trillion(U.S.) or, quite possibly, Congress could extend the suspension period for severalmonths yet.  In either case, as mentionedin our previous publications, it is absurd to believe that such debt levelswill ever be repaid.      

With the debasement of currencies likely to continueunabated, investors can protect themselves by owning gold bullion, gold coinsand shares of gold-mining companies.  See also, Companies We Like: researched, reviewed and listed onour website by Ian Gordon.  If youmust hold some fixed income securities in your portfolio, for reasons ofcapital preservation and a predictable income stream, ensure your holdings areof the highest credit rating possible and implement a laddered schedule over amid-term maturity range.

Ian Gordon,

-- Posted Tuesday, 21 May 2013 | Digg This Article | Source:

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