Honest Money vs Worthless Paper Money

During the last 50 years the US dollar has gained the status of the world’s primary reserve currency. One against which all commodities are priced. This unique status has allowed the United States to continue to raise its debt ceiling limits, to spend much more than the domestic economy really allows for, and, in recent years, to print money on an unprecedented scale.

As we relay in a feature piece in the latest edition of our magazine, until 1971, the gold standard worked as an effective self-discipline imposed on government spending. The money supply of the major economies that operated on this basis, was relatively stable for more than 100 years. The price of gold changed very little, and inflation was muted. Full convertibility between the dollar and gold prevented the US government from trying to monetize its debts.

In 1971, everything changed in terms of money and monetary policy. Richard Nixon kicked the gold standard away to allow for much increased government spending. A situation of full gold convertibility, along with undisciplined spending would eventually lead to government default and so to avoid that, the FED would need to expand the money supply. With a growing supply of money however, the value of gold would of course rise materially and everyone would want to sell the dollar to receive gold unless interest rates were raised. Not surprisingly, that was undesirable to the then administration and so the only solution was ending the gold standard and starting a paper currency system under which the dollar would have legal tender under the good faith of the US government (no pun intended!).

During the gold standard, between 1873 and 1971, inflation in the US averaged 1.36%. In fact, if we remove from this data the war periods between 1861-1865 (American Civil War) and 1914-1920 (World War I), during which full convertibility between dollar and gold didn’t really exist, the average inflation rate was a miniscule 0.64% per year. Between 1972 and 2012, the average rate of inflation was 4.36%, much higher than it was during the gold standard years. A basket of goods and services costing $1,000 in 1930 would cost $2,424 in 1971 and $14,004 in 2012. In a period of 41 years between 1930 and 1971, $1 was devalued to be worth just $0.41 in 1971. If we take the same 41-year period but now between 1971 and 2012, $1 has been devalued to be worth, amazingly, a tiny $0.17!

If you think the devaluation of the dollar as measured by a basket of goods and services is huge, then just look at the stats for the appreciation of gold against this fair money. Gold was valued around $35/oz during the gold standard and is now quoted near $1,400. This rise reflects a 98% drop in the dollar relative to gold. With the FED expanding its balance sheet from a few billions in the 70s to $3.3 trillion in 2013 and with US debt currently nearing $17 trillion; the massive rise in gold price comes as no surprise.

The US government has been raising ever more debt whilst pressing the FED to keep long-term borrowing costs at low levels. That, is in reality, the only way they can continue to pay interest and to keep on raising debt. Without the FED’s help, the US government just could not borrow at under 2% with a debt pile worth $17 trillion. US treasuries are safe as long as the US government will always be able to print money to pay you. But, that happens at a cost. That cost is inflation and that is the other side of the coin to a default for many economists – just ask the Zimbabwean central bank head!!

The value of money should always be measured in terms of what it can buy. Consider this – if the government defaults on debt and pays you just $70 for each $100 of face value, that wouldn’t be much different from paying you $100 which just buys $70 worth of goods (as compared with the moment you invested in).

With government spending continuing to rise through the roof, the FED has been trying to substitute fiscal policy with monetary policy but without any real clue as to its effectiveness. The central idea has been to create jobs and economic activity by expanding the money supply. During Alan Greenspan’s era, a tech bubble was created and in only 6 years after it burst, Ben Bernanke’s era then presided over a housing bubble. Now, we have, arguably, a new bubble with equities. The excess money supply is finding successive homes.

Paper money, or fiat currency, is in effect, a dishonest way of taxing money and of transferring wealth. It works as a tax on savers and it leads to unwise decisions by households and companies. Recent past shows that households and companies engaged in too much debt due to irresponsible policy. They also lost a substantial part of their savings as the housing bubble burst. The manipulation of money doesn’t add to overall wealth and should be avoided at all costs. The return of a form of the gold standard is a potential solution to avoid these problems as it inflicts discipline on central bankers.

Printing money simply can’t go forever or you wind up as a banana republic. At some point the FED will have to stop. The US government will also have to stop raising its overall debt. Absent this, people will eventually lose confidence in the ability of the US government to repay its debts, inflation will pick up, and the very reserve status of the dollar may be at stake in the very near future. It has already happened to many other countries over thousands of years and sometime it will happen in the US. The difference here is that such a crisis, given the globalised basis of trade today, would depress the world economy with likely much worse results than seen during the Great Depression. After that, we hazard a guess, that a new kind of gold standard will be adopted and we will have come full circle.