The Dismal History of Phony Money

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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.

December
6, 2006

Addison
Wiggin [send him mail]
is the editorial director and publisher of The Daily Reckoning.
He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century
and the upcoming Empire
of Debt
. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments
.

Addison
Wiggin Archives

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