This ancient Chinese Curse certainly holds true for us. We are living at a time that our children will look back and consider to be an important inflexion point in mankind's economic and financial history.
The symbol of America's might (no - not the 11 carrier battle groups, but...) the almighty US $ is on its deathbed. After almost two decades of too loose monetary policy the sins of Greenspan have finally caught up with us all.
I fully expect that within the next decade the US $ will no longer be the world's reserve currency. International Financial flows will now be denominated in some other currency. This new currency may be an existing one, but in all likelihood the signs point to a new monetary system - perhaps backed by precious metal and commodities.
This seismic shift will change the world as we know it and will create opportunities for the prepared and trap those still looking towards the old system to regenerate itself.
To anticipate the future one must be aware of the process of going from past to present. In this series I will attempt to trace the evolution of the current monetary system, and look back at the various mis-steps that signal its ultimate demise. To conclude thise series I will anticipate different scenarios that may crop up - and how best to be prepared for them.
Money
To the man on the street money is the coins and bills that he has in his wallet and the balance in his bank account. In general we don't spend much time worrying about what money is. Its more important to us that we get more. People worry about what money IS only when money ceases to function properly.
Wikipedia defines money as a good that acts as a:
Unit of Account, Store of Value, Medium of Exchange
But in my view Money is first and foremost a "Medium of Exchange" - all other definitions follow as corrolaries of that. In this function money makes possible the exchange of goods and services, without it nothing but the most basic form of goods and services (a hunter-gatherer economy) is possible.
Throughout history man has used various goods as money - sea-shells, animal skin/fur, livestock and precious metal. All these goods were portable, imperishable, retain (or increase in) value and had the same percieved value in the mind of the buyer and the seller. It is critical that these characteristics be applicable to all goods that are used as money because it is only these contribute to money's intrinsic value.
Think about it this way, if I were to sell you a product and you would give me money in return. But if that money were to vanish (i.e. rot away or dissolve in rain...) or lose its value before I can engage in another transaction the money itself would not be of much use and I would not use it as my medium.
It turns out that the easiest way to ensure that is to use different commodities as money. After all a barrel of oil is a barrel oil to both the buyer and a seller. This so-called "commodity money" - especially precious metals was widely used in most major economies up until the Industrial Revolution.
Since then various governments have issued currency that have been backed by Gold. In which case the government issues what is essentially a bearer cheque - that is backed by the balance that the government treasury has in terms of gold.
This is the "Gold Standard" - this basically means that a government issues currency equal to only what it has in Gold in its vaults. In which case one unit of the currency gives the bearer claim to a certain amount of gold that is secured in the government's vault. The amount of gold that the currency unit is redeemable for is the "currency-peg" and ensures that the currency does not lose its value.
The US $ was on the Gold Standard from 1880-1914. WWI forced all the major economies to print more currency than could be supported by the Gold in their vaults. In the aftermath of the Second World War - the western economies established the Bretton Woods Framework this essentially meant that all currencies of the world would be pegged to the US Dollar and the US Dollar would be pegged to the value of Gold. To be precise 1 US $ = 888.671 milligrams of Gold. The US Treasury also promised to redeem dollars for Gold should anyone (any Central Bank to be precise) ask for it.
In 1971 (again forced by War - Vietnam in this case) Nixon removed the US Dollar from the Gold Standard. Since then no currency in the world has been backed by Gold.
Instead the current monetary system in its place is a fiat money system. Fiat money is backed by faith in the government that it will make good its promise to repay its obligation. In a fiat money system, money is not backed by any physical commodity but rather the only thing that gives it value is its relative scarcity.
Consider this: When you exchange a good or service for currency. You are recieiving a promissory note from the government's Treasury. If the currency is backed by gold (or silver or some precious metal) - then you have received a promissory note that is backed by an asset. The Treasury is obligated to return to you an equivalent amount of the asset in lieu of the currency should you wish to redeem it. On the other hand in a fiat currency all you receive is a promissory note that is backed the credit of the issuer i.e. the Treasury. The Treasury is not obligated to return anything, the currency's holder simply believes in the Treasury to make good it's debt. A currency backed by credit is thus as good as the intent of the issuer to repay its obligations. Unfortunately History has numerous examples where the issuer's intent has not been so honorable.
Fiat Money - A brief history of financial armageddon.
Fiat money systems have been around for a long - long time. The first recorded instance of fiat money, is the Roman Emperor Nero (yes the one who played his fiddle while Rome burned) who in 64 AD got the idea of putting less silver in his coinage and decreed that the value of the coinage would be worth the same in silver - inspite of there being less of it. This allowed the emperor to continue his lavish spending and caused the wealthy to either hide their wealth or flee from the confiscating government. This did not have a happy ending as we know.
In the 9th century the Chinese started experimenting with paper money. In 1023 the S'ung issued the first real paper notes - these notes would be valid for 3 years and then redeemed at a 3% charge to face value after that period. Unfortunately the abuses started immediately, though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.In 1790 - revolutionary French Government confiscated land from aristocrats and issued "assignats" which paid interest against the properties. Land was auctioned off in exchange for these notes, inflation rose to 13,000% by 1795.
In 1862 Abraham "Honest" Lincoln passed the Legal Tender Act allowing the Government to issue paper money, backed by nothing but government promises. A huge inflation transpired that caused the practice to fall out of favor until the Federal Reserve System was put in place in 1913.
In the aftermath of WWI - the Weimar Republic (Germany after the Kaiser had abdicated) found itself destitute and unable to pay reparations to the Victorious Allies. So they printed money in huge quantities to pay reparations.
The inevitable consequence was inflation the likes of which history had never seen before.
In Weimar people had to bring a Wheelbarrow of currency to buy groceries, householders heated their homes by buring Marks instead of firewood (because it was cheaper to burn it with currency). I had an economics professor who had lived through the holocaust and he told us a story of his father in Weimar Germany. His father had bought an insurance policy in about 1905 and paid the premiums for about 25 years, then around 1930 he cashed the policy and with the proceeds he bought a loaf of bread.
But the collapse of fiat money is not limited to history. In this present day and age Zimbabwe is perhaps the posterchild of the excesses of fiat money. In Zimbabwe this is what the bill for a Dinner for one looks like:
This is a 250,000,000 Zimbabwe Dollar Bill - about 10 cents as of 8th June 2008:
A Zimbabwe Currency has an expiration date and is technically worthless after it expires.
Fiat and Fraud
Fiat money is always issued by the monetary authority. The way this works is that the Government (i.e. the legislative branch) requires money to fund its expenses and its current income (through taxes) doesn't cover its total expenses. This so-called fiscal deficit needs to be made up through debt. So the government asks the monetary authority - the Central Bank, to issue it currency to make up the fiscal deficit. The government issues an IOU (also known as a Treasury Note or Treasury Bill) and the Central Bank simply prints the cash in exchange for this IOU. The Bank of course charges an interest rate from the government and the government makes this interest payment to the holder of the IOU. The government then merrily proceeds to exchange this cash for goods and services that it needs. Voila! we have now created money out of thin air.
OK so now that we have created money and the Government has exchanged it with other producers and citizens for real goods and services. Why does the citizenry continue accepting this currency when they know fully well that this is simply paper backed only by their belief in the Government's intentions. The answer is twofold.
The Government has mandated that this currencyis the ONLY legal "medium of exchange" for transactions and no other currency or commodity can be used in its place. Secondly the government accepts this fiat currency for payment of taxes - this in turn creates demand for the fiat currency.
These are the two pillars that make a fiat currency possible, by forcing people to use the fiat money and by creating demand we forget that the intrinsic value of the currency is the belief that the Government will make its debt to the Central Bank.
But what if it never does, what if the "fiscal deficit" is never reduced but keeps on increasing and increasing.... what if the government simply keeps rolling over the debt? In which case the Government's intent is to defraud the holder of the IOU.
Unfortunately we have historical evidence that fiat currencies ALWAYS suffer from the dishonorable intention of the issuer. In other words FIAT = FRAUD
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