My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
We discussed John Law last week on how he misused the French money systems to the point of bankruptcy, see: Click here for Issue 10 In this Issue we will be looking at the flaws in John Law’s theories and how some of our modern, debt-based money systems work.
MONEY
To those who use well what they are given, even more will be given, and they will have abundance. But from those who do nothing, even what little they have will be taken away.
Bible: New Living Translation – 2007- Matthew25:29
Lessons of John Law’s theories
There are parallels between the unfolding experiment in contemporary managed electronic “money” with credit issuance and John Law’s disastrous experimental introduction of paper money in eighteenth century France. Similar to Law, present day central bankers see “money” simply as a medium – an expedient – for spurring spending throughout the real economy as well as in securities and asset markets.
Central banks are now in the process of creating trillions of dollars through bond issuance in order to inflate prices and encourage economic activity by merely adding electronic zeros to their government accounting records. In any rational economy this would be ‘counterfeiting,’ or to be blunt fraud, but it is acceptable to our current financial regime because this kind of debt is not the same as household debt, the type with which we are most familiar.
It is a real challenge to explain the flaws with our current debt-based, inflationary central bank doctrine. When inflation is not a problem why not just create some additional “money”? Central bankers think they can always reverse course and withdraw this excess money if or when necessary
This is what the Fed is doing in 2018 as they implement Quantitative Tightening (QT) by either allowing the bonds they hold to liquidate upon maturity or even sell bonds into the open market. This has the effect of reducing the amount of USD in circulation and tends to increase the value of USD against other currencies.
Markets are currently at or near record highs but the myriad risks associated with currency devaluation, monetary degradation, miss-priced finance, inappropriate incentives, resource misallocation, asset bubbles, inequitable wealth distribution and economic maladjustment don’t resonate all that well. Even the upheavals in Italy, Greece, Ireland, Portugal, Spain and Cyprus et al are viewed by central bankers as local problems and not the result of misapplied global financial models.
The modern debt-based economy
Charles Rist titled his first Chapter, “Confusion between Credit and Money in the Political Economy in the Eighteenth Century.” In our 21st Century of runaway electronic money-based finance, the distinction between ‘money’ and ‘credit’ has been completely blurred. Indeed there is a very important difference: Credit is much more about confidence, whilst money in its true form of gold and silver, has real value and is a store of wealth guarding against inflation caused by fiat currency systems.
Excess credit, exemplified between 2006 and 2008, can be robust, whimsical, fleeting and frighteningly fragile. ‘Money’, perceived as a trusted fungible store of nominal value, is the rock foundation for the entire financial system. As such, ‘money’ enjoys almost insatiable demand. And this attribute has ensured repeated episodes of gross over-issuance of paper notes and credit that has plagued mankind for centuries. Recent examples include Zimbabwe in 2000s and Venezuela currently. These days ‘money’ is the privileged and exclusive domain of government debt and central banks.
When his “Mississippi Bubble” scheme was faltering in 1720, John Law moved to devalue competing ‘hard’ currencies like gold. He was desperate to keep investors, and in particular the manic crowd of speculators, in his monetary instruments in order to stave off collapse.
All the central banks today have been working desperately to keep investors and speculators fully engaged in global debt, equities, bonds and risk markets. With near zero interest-rates and trillions of USD, ‘money’ is being methodically devalued around the world. Devaluation is forcing savers out of ‘money’ and into risk markets like the stock market, apparently believing that market price increases will spur wealth-creation, risk-taking and economic activity; but they might be wrong.
Global risk of excess credit issuance
The central bankers seem oblivious to the fact that they are on a perilous course that risks not only a crisis of confidence in ‘money,’ but also in global markets generally. The history of monetary fiascos is replete with ‘out-of-control’ inflations.
Once bond issuance escalates, there is a strong connection for one year of elevated bond issuance to create even more the following year. This dynamic has been in play for decades now and, after having studied the theory of these types of dynamics, it is almost surreal to witness them, now, in real time.
It is clear that money is a fundamental part of the banking system and is used also as a unit of account in all commercial transactions. To see how the jigsaw pieces of money and banking fit together we need to review the banking systems in general and central banking arrangements in particular.
However, before moving on, perhaps a note about gold and silver (known as: precious metals or PM) will clarify the differences between real money that is gold and illusory money otherwise known as fiat currency.
The gold standard of yesteryear
The gold standard was used during the 19th and 20th centuries (until finally abandoned in1971) to keep the price of a nation’s currency constant by the government’s promise to buy and sell gold at a fixed price in terms of the base fiat currency, e.g. USD , British Pound (GBP) et al.
Under this system the total amount of bank notes and coins in circulation plus credit and bank reserves are backed by the amount of gold held in central bank vaults. This limited the growth rate of the economy and is now not used. In its place, central banks control the issue of currency and commercial banks control the issue of credit in the form of loans and other financial advances.
However this does not mean that gold is no longer important. As we shall see it is very much at the centre of the global financial systems and is still considered to be ‘real money’ by many people who wish to hold their wealth in ‘bullion’ as a guard against future inflation. So what is so special about gold bullion, also known as ‘physical gold’?
Gold has a limited supply (about 2,500 tonnes being mined per year) and most of the gold ever mined, estimated to be around 160,000 tonnes, is still in existence somewhere because it never deteriorates, it is always nice and shiny and exactly the same as the day it was mined.
Because of its limited and relatively fixed supply the price varies depending on the demand for it at any one time. Gold has always been in demand, forever in the open market, and the price of the physical metal measured in USD has tended to rise as paper currencies like the USD lose their value over time (inflation). Since 1900 the USD has lost 96% of its value (purchasing power parity – PPP) measured against the price of gold: Dollar depreciation over the years
The US dollar and the price of gold
Because the US dollar is used to buy/sell all kinds of commodities, the price of these goods varies depending on how many dollars are in circulation at any one time. Since the Federal Reserve – the ‘Fed’, the central bank of USA – has the sole privilege of issuing dollars there is no limit to the amount of dollars they can issue but if more dollars are issued than the market requires the value goes down – then more dollars are needed to buy the same amount of goods (dollar depreciation).
One of the Fed’s main tasks is to control the supply of dollars as world economies expand (economic growth). The spot price (price today) of gold in US dollars always reflects the true state of the amount of dollars being issued; as more dollars are put into circulation the dollar price of gold increases and left to normal market forces will always reflect the true rate of depreciation of the dollar.
As long as the USA spends less than the amount it earns the Fed can keep a balance of dollars in the world economy and trade continues as usual in cycles, expanding and contracting naturally, as time passes (known as the ‘business cycle’).
A problem arises when the US government begins to spend more than it earns because: where can it get more dollars? It’s no problem they say, just ask the Treasury to issue more bonds and have the Fed buy them up with new money, triggering rapid expenditure of the money raised. In fact this does not increase the actual money supply, the mechanics of which will be described in later Issues of The Financial Jigsaw.
The dollar price of gold
Rarely noticed at first, suddenly the price of gold begins to rise which is what happened in the 1970s when the dollar became unhitched from gold. If gold is allowed to rise in price unheeded the world will notice that they are being paid less and less in real terms for their goods and begin to avoid the dollar and trade in their own currencies.
This would cause the USA’s standard of living to fall quickly as they would have to pay more dollars for imports in foreign currencies potentially resulting in a recession. Before 15th August 1971 the dollar could be exchanged for a fixed amount of gold at a fixed price by agreement between all countries when settling their international trade debts. Two years later the financial markets began buying and selling contracts to purchase/sell gold at a future date – this created the ‘paper market’ for gold.
Thus a trader could purchase a paper contract that promised to deliver an amount of gold at a fixed date in the future, often 3-6 months forward. The price of the gold in the contract would generally be more than the present or ‘spot’ price because there are storage and transport fees, interest and insurance payments and other costs associated with handling any commodity.
But gold is different from any other commodity in that it has been accepted over millennia as a form of secure exchange for goods as well as a store of wealth. Now there are two separate markets for gold with different prices: the spot price for physical delivery of bullion immediately (the physical market) and the prices for future delivery contracts (the paper market).
To find out what happens next about the manipulation of gold prices versus the USD, read next week’s exciting issue (well, I think it’s exciting whereas others may just be bored to death!)
To be continued next Saturday
