By Joe Withrow
Author of ‘The Individual is Rising’
Gold has been money for most of recorded human history. Industrial capitalism operated on a global gold standard up until the world wars shredded Europe’s economy. In 1933, President Roosevelt criminalized private gold ownership using an executive order, and the U.S. government forced citizens to sell their gold at a below-market valuation. This gold was melted down into bricks and shipped to Fort Knox where KPMG says it still sits to this day.
The Bretton Woods Agreement was executed in 1944, which pegged the U.S. dollar to gold at $35 per ounce, and installed the dollar as the world’s reserve currency. Under Bretton Woods, all other national currencies were pegged to the dollar, and foreign central banks could exchange dollars for gold at the fixed rate.
The Bretton Woods Agreement required the U.S. government to maintain the dollar-to-gold exchange ratio, but that didn’t happen. The U.S. government instead ramped up the printing presses to power its “Guns and Butter” campaigns in the fifties and sixties. Eventually foreign central banks caught on and began to exchange their dollar reserves for gold through the gold window. Gold steadily flowed out of the U.S. Treasury until August 15, 1971 when President Nixon unilaterally closed the gold window and ended the U.S. dollar’s direct convertibility to gold.
This action thrust the entire world onto a fiat monetary standard where all currencies floated in value against one another. The word “fiat” is defined as: an arbitrary order or decree, and the word very literally means “let it be done” in Latin. Fiat money is simply money that comes into existence and derives its value exclusively from government decree.
Free market economists, specifically those of the Austrian school, decried this move immediately. Fiat money had been used on a national level on numerous occasions throughout history, they said, and each time it led to economic disaster. Now you want to try it on a global scale? You are asking for a catastrophe!
Many of the Austrians didn’t think the fiat system would even survive the decade.
The reason being is really just common sense: if you give a select group of people the ability to create money out of thin air then they are going to do just that. And they are going to keep on doing just that in greater quantities, especially when they discover that they can funnel the new money to their own friends and business partners. Here’s the kicker: each new monetary unit that comes into circulation necessarily steals value from all of the other monetary units in existence.
This is just basic economics, but French economist Richard Cantillon noticed something especially nefarious about this dynamic way back in the early 1700’s. When such a fiat money system is employed, the people who receive the new money first – always the politically connected and financial elite – become fantastically wealthy while everyone else becomes poorer over time. In other words, Cantillon said, this system actively transfers purchasing power away from everyone who holds money, and it funnels this purchasing power directly to the few people who are on the receiving end of the printing presses!
This came to be known as the Cantillon effect, and it is the sole reason for the massive wealth disparity that has come to exist in the U.S. over the past four decades. There is a reason why the suburbs surrounding Washington, DC have become the wealthiest counties in the country. The Federal Reserve has been systematically transferring the nation’s wealth to Washington (and New York) for forty years now.
The fiat monetary system has fundamentally transformed how the economy operates as well. Free market purists, of which I am one, can list numerous reasons why the Bretton Woods System was a crony fractional gold standard that was riddled with problems right from the start, but it did serve to restrict the creation of currency and credit to a certain degree.
Gold was the restrictive mechanism. The amount of currency and credit in circulation was tied directly to the amount of gold in the vaults. Though the system was imperfect, credit could only come from real savings which could only come from real production prior to 1971.
Contrast this to the creation of credit today. Banks are required to hold a fraction of deposits in reserve in order to issue credit. This reserve number is roughly 10%.
In other words, banks can issue a $1,000 loan for every $100 on deposit with a simple journal entry. But the $1,000 created by the loan typically finds its way back into the banking system. Very few people take out a loan and stuff the cash in their mattress; they usually use it to purchase something. The business or person on the receiving end of that transaction typically deposits the proceeds from the sale into their bank account. At that point there is an extra $1,000 floating around in the system… which means banks can now issue additional loans up to $10,000 on top of the new $1,000 deposit.
Now it may not be the same bank with the additional $1,000 deposit, but all of the banks are tied together via the central banking system so the net effect for the entire system is the same. The credit expansion feeds itself and self-perpetuates.
The U.S. national debt was effectively restricted by gold as well, as the Feds found out when French President Charles de Gaulle began shipping dollars back to the U.S. Treasury in exchange for gold.
Gold was like the fuddy-duddy who collected everyone’s car keys at the door of the college party. He would let you have a little bit of fun, but he drew a distinct line in the sand.
So what has happened to the economy since 1971 is not a mystery – everything can be traced back to the fact that we went from using real money to using money created from thin air. The data very clearly shows the results of this:
- The U.S. money supply has exploded since 1971.
- The cost of living has risen dramatically because of this monetary expansion.
- The U.S. national debt has exploded by a factor of 10 – it has quite literally doubled more than three times in forty years.
- Unfunded government liabilities have exploded all around the world – eclipsing $210 trillion in the U.S.
- Household debt has exploded significantly, and household debt-to-income has now surpassed 130%.
- Interest rates have been pushed negative around the world, and to near-zero in the U.S. which has prevented seniors and conservative investors from earning any real returns on their savings.
- Real money and savings have been replaced by credit – the entire economy has been hooked on cheap credit.
The perpetuation of this system depends entirely on continued credit expansion. The house of cards will fall as soon as the credit dries up.
Here’s the funny thing about this: the Baby Boomers have spent most of their adult lives immersed in this system. Their children have spent their entire lives in this system. This monetary system is anomalous from a historical perspective and it is completely unsustainable, but most people alive today consider it absolutely normal. They have known nothing else.
So the fiat money system has chugged right along with its booms and busts, seemingly oblivious to the mounting problems and the select few voices crying wolf. The system has hit road blocks several times during each decade, but it has overcome and persevered on each occasion – elevating asset prices in the U.S. to new highs as it advanced.
This has made the average investor complacent. Talk to your neighborhood financial professional and he will tell you decisively how it all works: Stocks always go up over time. So does real estate. Government bonds are your safe haven. Corrections happen from time to time – you just need to wait them out.
He’s not trying to trick you – that is what mainstream finance believes. Indeed, that’s mostly how it has worked for quite some time now. The normalcy bias is firmly entrenched.
What isn’t often considered, however, is that we haven’t seen the other side of the credit cycle since the fiat monetary system came to being. Credit has been expanding consistently, and interest rates have been falling since the early 1980’s. At some point the cycle has to turn.
That point may be rapidly approaching. The puppet masters are engaging in more and more aggressive policies in an effort to keep the system progressing forward.
Policymakers in Japan and Europe have already pushed sovereign interest rates into negative territory. Chinese policymakers, as of last week, have done the same. This is capitalism flipped upside down. Instead of receiving a rate of return on their capital, savers actually must pay interest to purchase government bonds or to keep their money in the bank.
Think about what this means for large institutional investors. Are they really going to deploy their capital in a way that guarantees a loss?
What about insurance companies? Millions of people and businesses around the world have bought insurance policies to protect their homes, businesses, property, and even entire cities. These insurance companies must maintain a huge cash reserve in order to honor their guarantees as claims come in. Are these companies going to keep their cash reserves in accounts that steadily eat away at their capital because of negative interest rates?
You could ask the same question about pension funds.
And how about individuals all around the world? Are people going to keep their money in the bank and watch their account steadily dwindle month in and month out? Aren’t deposit accounts supposed to protect capital in a liquid manner?
A general rule of thumb is that capital flows to where it is treated best. Right now, that place is the United States. With the rest of the world descending into negative interest rate territory, the Federal Reserve has actually been talking about raising interest rates.
It is only logical to expect huge amounts of capital to rush into the U.S. credit and financial markets to escape the ills of negative interest rates. But this would drive Treasury yields down and send the U.S. dollar skyrocketing relative to all other currencies which would cause massive imbalances in the global economy.
Here’s just one example: emerging market debt has exploded by more than 600% in the last ten years alone. This debt is denominated in dollars, but the emerging market debtors earn money in their own currencies. This means they must convert their currencies to dollars to service this debt. If the dollar-to-emerging market currency exchange ratio is too extreme then these debts simply cannot be paid. Then problems in the credit markets really start to cascade.
So if the Fed pursues its “normalization” policies then the global economy faces some major problems. But the Fed has taken a more dovish stance recently, and Janet Yellen has even name-dropped negative interest rates.
Will the Fed follow the world into the realm of negative interest rates to suppress the dollar and avoid shaking up the global economy? This of course would lead to a different set of problems. If all of the world’s major economies were submersed in negative interest rates, there would be no safe haven for the aforementioned economic actors to run to within the financial system. So what would they do?
Maybe they would just take it on the chin and let their capital gradually decay. Or, much more likely, they would move into physical cash and gold as a means to preserve their capital thus triggering a global bank run – something long thought conquered in the age of central banking.
Oh, and this is more than just a theory… a number of power players are already starting to do just that – move into physical cash and gold.
Could the Great Reset be at hand?
Of course, nobody knows for certain. Prominent Austrian economists thought the fiat monetary system would crash and burn a long time ago. They have been wrong for decades on this. Maybe they will be wrong for decades more… or maybe they will finally be proven right.
What’s important to take from this is that the rules of the game are changing. Those stuck within the old paradigm of mainstream finance have huge threats facing their retirement, and quite possibly even their current standard of living.