Sunday, July 14th 2013
I have been saying for a few years now that buying gold and especially silver bullion was a good idea. If you had followed my advice and bought silver two years ago at $50.00 an ounce you could have sold it a few days ago for a shade under $20.00.
To understand why I still stand by my advice, it is important to understand that buying gold and silver bullion should only be partially considered an investment. Instead, it should be viewed primarily as an insurance policy against monetary debasement/collapse. Whilst most of us have house insurance, the fact that our houses didn’t burn to the ground makes that policy a lousy investment. That still doesn’t mean it was a mistake to buy the policy. Over the last two years the cost of a silver insurance policy was steep, but I still believe it was worth the price.
In my last article: Reasons to Buy Gold and Silver Bullion
I explained why precious metals are an insurance against sudden devaluations of paper money. To understand why that is so important I wanted to give people an idea of how our current monetary system works and why it probably soon won’t.
What is Money?
The first thing you need to know is that what most of us call money (dollars, pounds, euros or yen etc.) are not actually money at all. They are in fact credit notes, (IOU’s) for real money; in most cases that means gold or silver. As mentioned in my last article, British pounds sterling still bear the “promise to pay” pounds (weight) of sterling silver; this promise has long since been broken.
Understanding this, we still need to know why using this “fake” money is problematic, to say the least. Despite the fact that we have all been using these notes as money all our lives, the system is not sustainable and is in fact in danger of an imminent crash.
How Money is Created
The system of money creation is complex and boring and I don’t intend to go through all the details here. For those who are inclined, I recommend reading the excellent free book, The Case Against the Fed by Murray Rothbard.
Essentially, all money is created by banks who loan it into existence. When banks lend you money, they don’t actually possess most of that money. Instead their banking licence allows them to pretend to credit your account with money. In the case of housing loans in particular, the banks can be fairly confident that you will write a check to the seller who will then immediately deposit the cheque back in the bank. Although this may be a different bank, it mostly balances out and banks borrow from each other overnight to ensure they have sufficient reserves to meet expected withdrawals. Of course if for any reason everyone decides to withdraw this fake money from a particular bank, there is a bank run and the bank collapses.
Assuming however that the bank remains solvent this new money will remain in existence until the loan is repaid, at which point it disappears.
Rather than launch into an explanation of the details of this scheme, I wanted to take a simple approach using a hypothetical situation to see where it is heading, no matter how the details are contrived.
(Money creation happens in a two tier system through central banks and private banks. The main reason for this system is simply to ensure the banking system operates as a cartel. Interest rates are effectively standardised and competition, which could undermine profitability is stymied. The added complexity is also useful in making this scheme more difficult to understand for the masses who are being fleeced.)
Imagine yourself living in a small community on a desert island, cut off from the world. The community survives by fishing and growing coconuts. Not being attracted to either of these professions you decide to open a fractional reserve banking franchise. You cut ten squares out of palm leaves, write the word “one dollar” on each and sign your name on them. You then lend these out to a borrower at 10% interest to use as money. Everything goes well with the new money being accepted and used by the community. Unfortunately at the end of the year, the borrower now has to repay not only the original ten dollars, but also one dollar in interest. This of course is impossible since only ten dollars exist on the whole island.
Only two scenarios are now possible. In the first scenario, the borrower defaults, at least on the interest owed. The second possibility is that you make a loan to another Islander who then goes out and spends the money. Our first borrower works hard and sells coconuts and fish for these new “dollars” which he then uses to repay his loan capital and interest, problem solved. From a lenders perspective, option two is obviously preferable to option one.
Having lent out 20 dollars and collected 11, the total money supply on the island is now 9 dollars and money owed to you is now 11 dollars, whoops we have deflation. Of course this is no problem as we simply have to make more loans to inflate the money supply back up. Under this system, money appears when it is loaned out and disappears when it is paid back or defaulted on. Unfortunately, the longer the scheme goes on, the greater the interest owed as a percentage of the total money supply. This means that there is a constant deflationary pressure on the system. Since a default on a loan immediately reduces the money supply even further, the pressure on other borrowers to find money to repay becomes greater and can trigger more defaults. This situation can turn rapidly into a toxic spiral of debt and money destruction (remember Lehman Brothers?). As a consequence of this situation, the amount of money in the system can increase or decrease rapidly. In contrast, a system which uses a commodity as money (such as gold or silver) the amount of money in circulation hardly varies due to the difficulty of producing them (digging them up).
Winners and Losers
At first however, this system works well. Apart from yourself, the borrowers are also gaining. People lending out real money would demand higher rates. The fake money you are creating lowers the cost of credit allowing borrowers to buy up productive assets (such as the best coconut farms) cheaply. The inflation of the money supply also starts to raise prices. By the time workers realise this and begin demanding pay rises they have already taken a pay cut and will never catch up again (in recent times technological improvements and double income families have masked real wage losses). Investors however are getting richer on the back of this cheap inflated credit.
As time goes by however, problems begin to compound. All the creditworthy borrowers are tapped out so to persuade people to borrow more, you need to lower interest rates further and further. Eventually you will also need to lower your lending standards start making loans to “subprime” coconut farmers.
With money so cheap and inflation now roaring people begin to make confused decisions. Marginal farming land (or other productive assets) which people would not normally waste time on is now being purchased with cheap credit and farmed pushing up its price. The profits from these enterprises do not justify the effort expended and don’t generate enough profit to pay the interest. However with rising prices people figure they can sell at a profit in the future locking in capital gains. As prices go up, the returns on these investments become comparatively even lower. Each person who buys just hopes to sell to a “bigger fool.”
Eventually of course, all the investors who might buy have already bought and are now looking to sell to the next guy. Since the next guy is also selling and no one is buying prices collapse. Investors are now left with unproductive assets worth pennies on the dollar and a huge debt which needs to be serviced.
This boom bust cycle is wrongly labelled as the business cycle. A more correct name would be the “credit cycle”. In the late nineties, US technology stocks blew into just such a bubble propelled by low interest rates. Companies with no earnings and shaky business models were selling for billions. After the crash, and the subsequent terror attacks on New York, interest rates were dropped right down to try to compensate and a new bubble formed in housing. When this bubble burst, it nearly took the whole world’s banking system down. Credit seized up triggering the “Global Financial Crisis” and banks wouldn’t even lend to each other, let alone anyone else. With interest rates near zero, they couldn’t be dropped further and special measures (money printing or “Quantitative Easing”) were needed.
Boom and Bust
These cycles have been repeating for many years now. Low interest rates spark a boom; the boom creates inflation and unsound investments. Rates are raised and a recession ensues where bad investments are liquidated and debts are written off. Inflation moderates and rates are then lowered to stimulate growth once more. Perversely, the recessions are necessary as they wipe out bad investments and set things up for a more sustainable boom. Obviously few people see things this way and the pressure is always on for lower rates and boom times.
The End Game
When recessions are allowed to happen, the deflation is taken in small hits which relieve some of the pressure. After a prolonged period of gradually lowering interest rates (in order to prevent recession), this pressure builds like a black hole desperately trying to collapse in on itself. Eventually there will inevitably be a major collapse leaving policymakers with only two options. The first is to allow nature to take its course, which means a deflationary collapse. The subsequent write offs of debt will wipe out the majority of the banking system and cause a savage recession where bad investments are written down or liquidated altogether (this happened commonly when paper money was still backed by a percentage of gold). The second alternative is for the banks to literally print money and give it away to ensure there is enough for people to pay their debts. Clearly, for the banks, this second option is far preferable to the first.
For a while, this process seems entirely benign as the new money is simply staving off deflation giving reasonable price stability. After a while however it will start to show up in rising asset prices. As people see this they once again begin borrowing at the low rates to take advantage of the situation.
Unfortunately, each new loan simultaneously debases the currency further whilst adding to the deflationary pressure through interest payments. This forces the banks to print even more money and pushes prices up further encouraging more borrowing and more money creation. Any attempt to raise rates or reduce money printing at this stage will spark vicious deflation, savaging asset prices and destroying the banking system which has lent against them.
When banks “give money away” it isn’t to the likes of you or me, at least not directly. Lowering rates to zero and lending directly to government means that they effectively “monetise” debt. That is, the government spends money it hasn’t got and the banks lend freshly printed money to pay for it. This money can never be paid back but with interest rates at zero, this isn’t a problem as it never has to be paid back.
This means the government gets “free” money to spend as it will. The reckless stupidity with which governments will spend this free money would embarrass the most drunken of sailors. Unfortunately this money is not just spent on “one off” items. Much of the expenditure is for ongoing expenses used to bribe a voting public. It may be money for the unemployed, failing industries, the disabled, pensioners, green industry, medical R&D or whatever. The list of well meaning, but ultimately unaffordable programs (as well as the outright corrupt pork barrelling) grows like a weed under the potent fertiliser of free government money. With a shrivelling private sector, more and more people become dependent on these free handouts and cutting back on these popular programs becomes political suicide.
Inflation eventually begins to spread into consumer items such as food and fuel. As people see prices rising faster and faster they are inclined to spend money quickly before it loses its value. This increased “velocity of money” signals a loss of confidence in the currency and is followed by spiralling prices and hyperinflation.
The reason I can write with such confidence about this situation is that it has happened many many times before. In the US they have a saying “not worth a continental”. A continental was a paper bank note, not redeemable in gold (as other money was at that time). These notes were printed to pay for the Civil War which was raging at the time and were forced on an unwilling population. (There is a connection between paper money systems and frivolous wars which is worthy of its own article.) Within a short time the government had printed so many that they lost all value, joining the long list of other unbacked (by gold or silver) currencies whose value was destroyed by money printing (see here for a list of the more recent ones).
Where Are We Now
Our current monetary system has only existed in its present form since August 1971 when President Nixon reneged on the convertibility of the US Dollar to gold. Prior to this it was the world’s reserve currency, tied to all others at fixed exchange rates creating a worldwide quasi gold standard known as the “Bretton Woods system”. Breaking the convertibility of paper money into gold allowed the US and most of the developed world to print money with abandon stoking severe inflation. At the end of the 1970’s however, Fed Chairman Paul Volker targeted inflation by raising interest rates right up around 16% causing a savage recession. Since then however, interest rates have been trending downwards. Currently, rates around the developed world are close to zero and many central banks are printing huge sums of money (Quantitative Easing) to prevent financial collapse and prop up an insolvent banking system.
They are currently in a “sweet spot” where, although this money printing is not stimulating the economy (of course), it is not yet showing up as consumer price inflation. When this does happen, it will likely accelerate at an alarming rate which will take peoples breath away and devastate societies and peoples way of life.
As paper money loses value, the only alternative will be real money, represented by gold and silver. The increased demand this will create means that they will appreciate in value not only against paper money, but even against other tangible goods.
Price Suppression of Precious Metals
In my previous article (here) I looked at ways that precious metals prices may be suppressed by banks and governments to make their own debt based money look more attractive. If this is the case then the current low prices make them worthy of a serious look for investment purposes. As Rick Rule famously said about commodity investors, “you are either a contrarian or a victim”. Right now, precious metals are about as contrarian as you can get with all but the staunchest supporters having sold out.
Gold and Silver as Insurance
It is possible in theory that our current paper money system will survive. If it does however, it will be the first time in history that unbacked paper money hasn’t lost all value. My own opinion is that modern economic theory exists purely to justify and inspire confidence in this system. There is certainly no scientific method employed and the underlying school of thought (Keynesian) which supports all modern economics is the only one which sees this system as a benefit.
This article is my attempt to explain the theories of the “Austrian School” of economics. To me, they make far more sense than the voodoo pedalled by the mainstream economics profession which seems entirely unable to understand, explain or predict even seismic events such as the GFC.
Most of us buy fire insurance for our houses which will almost certainly not burn down. Taking out insurance against monetary collapse which looks inevitable seems to me like a really good idea.
Even More Important
I believe a global monetary collapse would represent a catastrophe not seen in our lifetimes. I still believe however that humanity will recover from this event and rebuild, hopefully learning from the experience and creating a more stable and fairer economic system.
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Disclaimer: this article is for information only. I am not selling anything and I urge everyone to do their own research and make up their own minds regarding any financial investments. Also please note that gold and silver in your own possession carries no “counterparty risk." No matter who goes bankrupt you still own this “money”. The same is not true for mining shares, futures contracts, ETF’s, or derivatives. Be aware that mining shares also carry a number of political and business risks which mean that they do not always move in the same direction as the gold price.