Following my decision last November to quit writing these reports, I was inundated with a flood of emails requesting me to continue writing. The emails are still arriving some six months later. The power of communication via the Internet web sites is truly astonishing and I had no idea of the huge readership that I had developed.
The publication of this commentary does not mean that I plan to resume writing. The decision to stop writing remains unchanged. The main purpose of this communication is to thank everyone who wrote such wonderful emails to me. I read them all, but replying individually would have been a physical impossibility.
I will, however, take this opportunity to review the current economic and financial situation, dust off a centuries old law that has a modern corollary and finally suggest a possible way in which this debacle may end.
There is little doubt in my mind that the current crisis arose because of unsound money and a flawed international monetary system. This point of view was discussed in several previous articles, but most notably “Chaos Chronicled”, which was published in April 2008.
Virtually everyone born after the early 1950’s has lived their entire adult and working lives under a fiat monetary system, i.e. a system where the money is something which the Government declares is money. Since August 1971, when President Nixon cut the link between the US dollar and gold, Governments have had the right and the ability to create virtually any amount of new local fiat money at will. The majority of economically active people today only know fiat currency as “money”.
Sadly the history of money and monetary systems is not taught in universities and other institutions that train economists and financial analysts. This is the reason why so many people do not understand what has been happening over the past four decades and why younger analysts and stockbrokers have no idea of the monetary properties of gold. I got tired of trying to tell people about gold and the problems in the monetary systems, national and international. Their eyes would just glaze over and the subject would be changed. No doubt others will have had similar experiences. That is why I started writing these reports, to try to educate people.
The fact is that anyone with an understanding of monetary history could have predicted the inevitability of the current financial crisis. Only the timing of the onset of the crisis and the trigger that started it were areas of uncertainty. I first publicly predicted the current crisis at the Gold Rush 21 Conference in August 2005. I was a delegate, not a featured speaker. The talk was impromptu and off the cuff.
Someone has kindly placed a video copy of that talk on the internet and it can be accessed at:
That talk referred to the fact that all the problems then emerging in the US economy started with the letter “D”. It is appropriate to review the progress of these various problem sections of the economy. They now include a couple of new ones:
- Debt: This was discussed in detail in the “Crisis Cogitations” article. Deleveraging is taking place with debt totals declining. The nominal value of GDP needs to be increased to help sustain the debt levels. Government debt will replace and then exceed the private debt that is currently being eliminated.
- Deficits: These cover both the US Government Budget deficit and the external trade deficit. The trade deficit is declining but the Budget deficit is about to go exponential. This is where the rubber hits the road. Cash required for all of the other D’s will eventually filter into the budget deficit.
- Dollar: The US Dollar is a major problem as other countries recognise that the US dollar cannot continue as the world’s Reserve Currency.
- Deflation: Caused by the debt and credit collapse – and may even lead to the other D-word, Depression. The worse the economic downturn becomes, the greater will be the efforts to turn the economy around, all requiring increasing Federal Budget deficits. This applies to all countries around the world.
- Demographics: The Baby Boomers have entered their retirement phase, which means that there will be increasing claims for pensions, social security and medical entitlements for which the Government has no resources. These unfunded claims could amount to a total of more than $40 trillion, all of which will swell the budget deficit for years to come.
- Derivatives: This is the “biggie”, running into many hundreds of $ trillions at notional values. Huge losses are already emerging from this area, which have nearly sunk AIG and the banking system. Nobody knows where the losses will settle, but it seems a foregone conclusion that they will be massive, eventually finding their way into increasing US budget deficits and debt.
- Dwellings: The slump in real estate is far from over and attempts to assist in this area will also swell the US budget deficits.
- Destruction: Wars in Iraq and Afghanistan continue to cost vast amounts of money, all funded by additional budget deficits.
- Deceit: This is a new one. The first casualty of war is truth. Lies, deceptions and misinformation abound in a war situation. Whether we like it or not, we are all involved in a war between government fiat currency and sound money. Governments will not willingly give up their right to create new fiat money. We must expect Governments to fight the introduction of sound money with whatever tools they have, which will include propaganda and misinformation.
Realistically we must assume that the world economy will continue to wind down. Deleveraging is continuing apace and people are scared. In such circumstances one cannot expect people to borrow and spend with gay abandon. That will not happen. People have become conservative and will save or repay debt to improve personal balance sheets. It is probable that unemployment numbers will continue to escalate, possibly sharply. Unemployment in the USA has reached 8.1% and will almost certainly go higher. We cannot exclude the possibility of a 20% unemployment rate.
When the economy tanks and unemployment rises, two things happen to the US Government budget. Expenditures increase due to higher unemployment claims while Government revenues decline as tax receipts plummet. The result is that Government budget deficits mushroom rapidly. These deficits are then aggravated by spending on stimulus packages, money thrown at supporting the banking system and the “too big to fail” corporations.
Bloomberg has estimated that all the various packages thus far propagated by the US government total more than $12 trillion. Where will this huge amount of money come from? It comes from the US budget, to be found in ballooning deficit numbers.
How does the US government raise the money to fund these deficits? Increasing taxes would have a detrimental impact on the economy, so that will not happen. Can the money be borrowed? Not in the quantities that will be needed, and $12 trillion may only be the first pass at a much, much higher final number. Money to fund the deficits can only come from selling Treasury Bonds to the Fed in exchange for newly created fiat US dollars. That is already happening and is a trend that will rapidly escalate .
As mentioned above, this is where the rubber hits the road, not only for the USA but in countries around the world. Escalating national budget deficits will be financed by newly created local fiat money. The frightening thing is that whereas this situation has occurred in individual countries from time to time throughout history, this is the first time that it is happening world wide in virtually every country at the same time.
Where does this lead to? It is time to dust off the centuries old “Gresham’s Law”.
Sir Thomas Gresham was an English financier who lived nearly 500 years ago. His Law states that “bad money drives out good money” What he meant was that people will hoard “good” money while spending the “bad” money.
Gresham lived in an era of metallic money and the “bad” money he referred to related to coins that had been clipped or had been debased by having some of the precious metal content supplanted by base metals. The “good” coins were hoarded and disappeared from circulation. People got rid of the “bad” money while they could still find someone to accept it.
There is a corollary to Gresham’s law that applies to the modern situation when a country rapidly increases the fiat currency in circulation. Initially people exchange the local “bad” currency for foreign “good” currency (or gold) and hoard the good money. Gradually the locals introduce the use of foreign currency into every day trade and eventually the local fiat currency is spurned. At some point Gresham’s Law is reversed. The “good” money drives the “bad” out of circulation.
This is exactly what happened in Zimbabwe recently. Initially South African Rand and US Dollars were hoarded by Zimbabweans. Subsequently these currencies emerged in every day trade until the Government had to accept the de facto situation that they could no longer spend Zimbabwe dollars in Zimbabwe. The people would not accept them. The Government eventually announced that trade in Zimbabwe could be conducted in any foreign currency. “Good” money had replaced the “bad”.
History is littered with similar examples. Virtually all South American countries went through a similar process 30 years ago where the bad money was eventually driven out by the good money, which at the time was the US dollar.
The downfall of the Roman Empire included a similar set of circumstances. Roman government spending reached a point where it exceeded the income raised in taxes and tributes. The Emperor raised taxes to cover the deficit, but citizens voted with their feet and departed from Rome to avoid the higher taxes. Tax collections declined.
The Emperor refused to cut expenditures and finally resorted to debasing the silver currency to cover the deficit. Initially this worked while the population remained unaware of the minor reductions in the silver content of the coins. This could not be hidden when the reductions in silver content became more obvious. Eventually the silver content was reduced by 95% in just a few years. The Roman Legions rejected the debased currency. Without an army, the Roman Empire collapsed
I recently visited Vietnam for the first time. It was basically a tourist visit, but I was interested in monetary developments in that country. The local currency, the Dong, is not an internationally exchangeable currency and has showed signs of moving in the direction of the Zimbabwe dollar.
The first thing that made an impression was a question on the Vietnamese arrival form. Immediately following the normal question: “Are you carrying more than $10,000 in cash or convertible currencies?” was another question: “Are you carrying more than 300 grams of gold? If so, list the gold that you are carrying.”
This is an interesting development. Be prepared for this question to soon be inserted on arrival forms near you.
Virtually all trade in Vietnam can be conducted in either Dong or in US Dollars. Every Vietnamese can instantly quote the price in either currency. The locals spend Dong while US Dollars are hoarded. Gresham’s Law is alive and well in Vietnam. The Vietnamese are also well versed in the benefits of holding gold as “good” money. This article suggests that the Vietnamese people hold a total of 700 tonnes of gold, a huge amount for such a small country:
It will be interesting to follow developments in Vietnam.
How will the current crisis end?
How will the current crisis end? As mentioned, this is a war between fiat money and sound money. It is extremely unlikely that Governments will voluntarily give up their freedom to create fiat money at will. They will have to reach a point where there is no alternative to introducing sound money because citizens finally refuse to accept the fiat currencies. This journey will probably be decidedly unpleasant.
Fiat money will survive for as long as people are prepared to accept it in payment for goods and services. The end will come when the general populace rejects the fiat currency in favour of sound or “good” money.
The bottom line is that it is the people who will finally decide when this crisis will end, when they reject bad money and force the good, sound money into circulation.
How can this happen in the USA? We need to go back to examine the basics of banking. Centuries ago goldsmiths, the forerunners of modern banks, provided a storage service for metallic coin money. The receipts they issued were regarded as being as good as gold and enabled commercial transactions to take place easily. The goldsmiths’ profit came from storage charges.
Later the goldsmiths started issuing receipts for their own gold as loans and charging interest on those loans. Then they started lending fictitious receipts based on the gold they were holding in storage for clients. That was when they morphed from the sound business of storage into the murky waters of lending money belonging to others.
The same two functions are performed by modern banks – the transaction function and the loan function. The transaction function is easy, safe, but unexciting business. The loan function is much more profitable and invites risk taking. This is where problems normally emerge.
With the development of electronic money and electronic banking, the transaction function has become vital to continuing economic activity. This is why Governments are so determined to save their national banking systems, but this requires them to absorb all the bad investments and derivatives from the loan side of the banks.
It seems inevitable that before this crisis is resolved, that the two functions performed by banks, the transaction function and the loan function, will need to be separated.
It also seems inevitable that when government fiat money is rejected by the people, (following unbridled creation of new fiat money), that gold and silver will have to re-enter the national and international monetary systems. In our modern economies, with their electronic money transaction systems, gold and silver will need to be in an electronic format to be reintroduced as money.
Electronic gold and silver money already exists. Some people (ahead of their time) have perceived this need and set up the electronic transaction function of a banking system using gold and silver. James Turk at www.goldmoney.com is one such person. Their business provides a facility for people to open electronic gold and silver accounts. Goldmoney.com buys and holds the precious metals on behalf of clients who can use their holdings to make electronic payments from their accounts, either in gold or silver or by converting back to fiat currencies.
Goldmoney.com makes its profits from minor transaction fees and small margins between the buying and selling prices of precious metals. They only provide the storage and transaction functions of a bank. They do not get involved in the loan function. Thus goldmoney.com has also achieved the separation of the loan and transaction functions of a banking system.
I have no connection with goldmoney.com and only mention their business as an example of how good money may evolve and eventually drive out the less desirable fiat money from circulation. If you use goldmoney.com or any similar business, please be aware that you must do your own due diligence to satisfy yourself of the security of the operation.
What to do in the interim?
Nobody can be certain how the various forces will play out in the period ahead, but if events unfold along the lines described in this article, then there should be a massive transfer of wealth from fiat money and financial assets into tangible assets.
The top tangible assets will be the precious metals that should form the basis of the new sound monetary system. Gold and silver, but particularly gold, will be the main financial life preservers. The ship has been holed and is sinking. This is not the time to take off your life jackets. Do not try and trade your precious metal positions.
Most people are uncomfortable holding too large a percentage of their assets in precious metals and related mining company shares. There are many other tangibles that can be considered, ranging from commodities, base metals, energy assets to real estate, equities and collectibles such as works of art by renowned artists. It is important to pick a suitable point in the valuation cycle to purchase tangibles such as real estate and equities.
A personal note.
My life changed two years ago with the birth of my first grandchild. There are now four grandchildren with number five on the way. I guess all grandfathers think that their grandchildren are the brightest, prettiest, cutest grandchildren ever. I am no different and find that I am spending increasing amounts of time helping with the grandchildren. I love watching their development, which always fills me with amazement. As a consequence I seem to be spending less time following events in financial markets and economies.
I recognise that if I continued writing these articles that I would find myself simply repeating much of what I have written before. There would be no fun in doing that. So it really is time for me to quit writing. If I have any talent, then it has been a gift from God that I have been happy to share freely. If on the journey I have helped a few people to understand what has been happening in a complex world, then that is sufficient reward.
25 November 2008
Disclosure and Disclaimer Statement: The author is not a disinterested party in that he has personal investments in gold and silver bullion, as well as in gold, silver, uranium and base metal mining shares. The author’s objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.