In my view, this new bout of turmoil in financial markets is the prelude
to the final demise of government currency.
If I’m right, a long-expected collapse in the purchasing power, and of the
very concept of fiat currency, will evolve from current events. The purpose
of this article is to explain why monetary theory predicts a currency
collapse.
The question at the heart of today’s market instability is the validity of
fiat currency; that is to say, forms of money issued and sanctioned by
individual governments, with no backing other than faith in those
governments’ creditworthiness, and the enforcement of its use by law. The
risks they impose on all of us will be evidenced one day by both the speed of
the fall in each individual fiat money’s purchasing power, and inevitably by
their comparison with gold’s more stable purchasing power. Essentially, an
awareness of the dangers of unsound money will gradually become evident to
every economic actor.
So far, or at least since the days when fiat money was freely exchangeable
for gold, central banks have managed to enforce upon us their currencies as
money, originally on the basis they were gold substitutes. That pretence was
finally dropped in 1971. The purchasing power of fiat currencies has never
been seriously challenged since, except in relatively few extreme cases, such
as Zimbabwe and Venezuela. Not even the financial crisis eight years ago
threatened a collapse in fiat currencies, when banks had to be rescued with
unlimited extra quantities of money and credit.
The current crisis has commenced while there are determined efforts to
stop the purchasing power of the major currencies from rising, even leading
to the deployment of negative interest rates in this quest. None of the
central banks’ policies appear to have worked. The increasing purchasing
power of the yen, despite all attempts to lessen it, is the clearest example
of the abject failure of a central bank to achieve its monetary objectives. The
same can be said of the ECB and the euro, a currency even more synthetic than
those it replaced. It is clear that the central banks are setting monetary
policy more in hope than in a true appreciation of their own hopelessness.
They place an undue emphasis on empirical evidence. That’s why charts and
statistics are so important to them and all their epigones. When you don’t
understand and cannot explain something, you turn to the so-called evidence.
And when very few people actually have a reasonable grasp of what money is
about, you can rely on empirical evidence being unchallenged. For monetary
policy, this tells us two things: central banks are clueless about monetary
theory, and in the event of a second systemic crisis, they will be misguided
by their experiences of the last one.
Today’s empirical evidence reflects the bail-out of the global banking
system in 2008/09. Neo-classical monetarists were initially worried by the
potential for price deflation in the wake of the banking system’s rescue, and
so central bankers expanded narrow money by unprecedented quantities to
counter credit deflation, real and anticipated. These were intended to be
short-term measures, to be replaced with more normal monetary policies as
soon as the immediate crisis was over. These short term measures are still in
place today eight years later.
The impact on the gold price
After the Lehman shock, which led to a temporary flight into both money
and short-term government debt, the purchasing power of currencies relative
to that of gold rose, with the gold price falling from $930 to $690.
Subsequently, when it became apparent that monetary expansion had succeeded
in curbing deflationary forces, this trend reversed, taking the gold price to
over $1900. That then changed in September 2011, following concerted central
bank intervention to supress the gold price.
The dollar-gold relationship has now turned once again, signalling that
the tide of confidence is moving against currencies. The purchasing power of
currencies measured against that of gold is now falling. We now have a
banking crisis in the making, if the share prices of major banks are any
indication. The UK’s decision by referendum to leave the EU points to
Europe’s political disintegration. Increasing market volatility tells us that
another systemic crisis may well be imminent, and government bonds reflect a
continuing flight to safety.
Already, the Bank of England has announced that a further £250bn in
monetary support will be made available to the banks, and that additional
swap lines have been agreed between the major central banks. We can take this
as evidence that the central banks, relying on empirical evidence, are
preparing a new round of monetary expansion as the solution to any future
crisis, confirmed in their belief that the risk to the credibility of their
currencies is unlikely to be a problem.
This is not what gold, when priced in these currencies, is telling us. To
understand why and where the central bankers are mistaken, we must consider
some fundamental points about how money actually works.
The theory of money and its purchasing power
To prepare our minds for a comprehensive understanding of monetary theory,
we must at the outset dispense with any idea that statistical analysis is
relevant. It is not, because there are no constants involved. Valid
statistics require at least one constant, usually the purchasing power of
money. In the whole field of economics, let alone money, there are none. The
purchasing power of money is to a large degree independent of its quantity,
and depends on a fluctuating acceptance that it is exchangeable for goods.
Quack monetarists that believe in the equation of exchange, despite all
evidence it does not work, overlook the subjective factors that qualify
something as money.
When we set out to understand money, we must acknowledge there are three
major influences at work, besides a general acceptance that a particular form
of money is exchangeable for goods. There is the subjective value of the
goods for which an exchange is considered, there are the fluctuations in the
relative quantities of goods and money in the exchange process, and there is
the balance of relative desires in the population as a whole to increase or
decrease the quantity of money held, relative to goods. All these factors are
the unknowable decision of every single economic actor, and fluctuate
accordingly.
This self-evident truth continually risks undermining the very function of
any particular form of money, which in order to be acceptable to the parties
in any transaction must have a commonly accepted value, even though one party
will want money more than the other at a given price. This commonly accepted
value has been described by the economist, von Mises, as money’s objective
exchange value. It is the one thing that parties to a transaction can agree
upon. A dollar is a dollar, a euro is a euro, and so on, even though
different individuals will want these forms of money more or less than other
individuals.
So far, we have addressed only one out of four dimensions of the money
problem. A second dimension is that demand for some goods is always greater
than demand for other goods, so money’s purchasing power will differ for
every good and class of good exchanged for it. It is never sufficient to just
assume that, for instance, the price of housing is rising solely due to
demand for housing. It also rises because people place a lower value on money
than they do on bricks and mortar. On reflection, this truth should be
self-evident. But it also holds true for every other good for which any
particular form of money is exchanged, and it is too simplistic to assume
that changes in price come from the goods side alone.
A third dimension to consider is that the products and quantities of goods
and services purchased yesterday will not be the same as the products bought
tomorrow. Besides making the point again, that statistics are wholly
irrelevant to understanding money, we can also add that what money will be
used to buy tomorrow and in what proportions cannot be predicted, beyond
perhaps some broad generalisations, such as people will buy food, they will
use energy, and they will enjoy some leisure time. Such platitudes are of no
practical value to understanding monetary theory, and disqualify the use of
price indices and aggregates such as gross domestic product.
The fourth dimension is one of time. The injection of money into an
economy will start at a point, typically the banks creating loans, or
governments through unfunded spending. Money therefore enters an economy
unevenly, benefitting some at the expense of others. This is known as the
Cantillon effect, and is universally ignored by the neo-classical economic
community.
The problem today
The reader should now have a grasp as to why attempts to discern future
purchasing powers for money are futile, and why monetary policies of central
banks never succeed, except perhaps by pure chance.
As if the four dimensions cited above were not enough, there is a further
problem. Most fiat money is produced not by central banks, as is commonly
supposed, but by commercial banks, which lend money into existence. Bank
credit is essentially temporary money, and is regularly extinguished in
credit cycles. It is the obvious potential for this bank credit to contract
which concerns central bankers most. When bank credit contracts, businesses
that are over-reliant on debt for their capital requirements, and companies
that have borrowed to finance unprofitable production go bankrupt. This is
the bust of the credit cycle. In recent decades, the bust has been deferred
and deferred and deferred, but hasn’t gone away.
The failure of central bank monetary policies appears to have reached an
inflection point. This is what the share prices of systemically-important
banks are telling us. This is what the political disintegration of Europe,
upon which the new synthetic euro is based, is telling us. This is what the
cul-de-sac of permanently zero and negative interest rates are telling us.
This is what wildly over-priced government bonds are telling us. This is what
the greatest indicator of all, the price of gold is now telling us.
The inflection point, I believe, is the marker for a potentially
catastrophic decline in the purchasing power of paper currencies that are
unbacked by exchangeable gold. The faith and credit-standing of issuers of
paper money, and not the known and suspected inadequacies of commercial
finance, is the last rotten pit-prop supporting the system. We can easily see
how a new round of monetary expansion designed to save the global banking
system from its nemesis will lead, not to a Lehman-style outcome, but to a
collapse of paper currencies.
This, apart from the implied forecast for gold in the paragraph before
last, is the only truly subjective statement in this article on a truly
subjective subject.
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