“The best things in life are free
But you can give them to the birds and bees
I want money
That’s what I want
That’s what I want
That’s what I want.”
- ‘Money’ by The Flying Lizards.
Get your Free
financial review
Our monetary system is dying.
According to the definitions of traditional economics, to qualify as money, whatever we use as money has to have three characteristics. It acts as a medium of exchange; i.e. we can use it to purchase goods and services without resorting to the cruder exchange represented by bartering. It acts as a unit of account, i.e. we can price things with varying degrees of value with it. And it acts as a store of value; i.e. we can choose to defer present spending and save using it – it retains our purchasing power over the longer term.
Over time, mankind has used all kinds of things as money, including cattle, shells, nails, tobacco, cotton, silver and gold.
“In the most developed societies, the precious metals have eventually been preferred to all other goods because their physical characteristics (scarcity, durability, divisibility, distinct look and sound, homogeneity through space and time, malleability, and beauty) make them particularly suitable to serve in this function.”
- Jorg Guido Hűlsmann, ‘The Ethics of Money Production’.
Paper money itself is a comparatively recent phenomenon – it came about after medieval merchants realised that carrying gold receipts was more practical and convenient than carrying physical bullion. These days, our money is almost comically insubstantial.
Less than 8% of all dollars are in the form of paper money or coins. Most dollars exist in purely electronic form. Paper money itself is an abstraction. Given that most of it has no physical form, it is what Satyajit Das calls the abstraction of an abstraction. It exists solely to act as a medium of exchange. There are no limits to the amount of money that can be created.
To make it clear, unbacked paper (or fiat – paper money made legal tender by government decree) is a distinctly modern experiment. It is not an experiment that is likely to end well, since in the entire history of humankind, no unbacked paper currency has ever lasted. They have all reverted to their intrinsic value, which, as Voltaire reminds us, is zero.
The modern banking system operates on what is called a fractional reserve basis: only a fraction of a bank’s deposits are kept as liquid reserves. The vast majority of deposits are lent out, re-deposited, and re-lent elsewhere. This mechanism normally works tolerably well, though in the event of a systemic loss of confidence, it has the unfortunate side-effect of bank runs.
There is one further huge side-effect of fiat money and fractional reserve banking: inflation. Monetary purists point out that inflation is not just defined as a generalised rise in the prices of goods and services – rather, it is the rise in the money supply that tends to ignite the rising prices that follow in its wake. To generate inflation, in other words, merely let politicians and central bankers print money and let their banker friends create more.
As the investment managers Lee Quaintance and Paul Brodsky describe it, money, per se, is base money (a measure known by economists as M0), which may only be created by central banks.
It is comprised of physical currencies in circulation and bank reserves held on deposit at central banks. Presently, there are nowhere near enough bank reserves to cover bank deposits (US bank deposits, for example, are unreserved by over 7:1). There is no need to fear bank runs, however. Were every bank depositor in the world to suddenly demand his or her money, central banks could easily create it with a few keystrokes. Herein lies a critical problem: central banks can easily create base money ex nihilo.
It requires no form of discipline or labour whatsoever. Central banks, in other words, have developed precisely the tools that will cause them to destabilise the global monetary system while they claim to be its saviours.
Government-sponsored paper money, in conjunction with fractional reserve banking, is inherently inflationary. Former US Federal Reserve chairman Alan Greenspan admitted as much when he acknowledged in 2005 that “we can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.” In other words, central bankers can print as much money as you want – just don’t expect it, over time, to be worth anything.
“Modern money is satisfying the requirements as units of account and media of exchange, but not the requirement as a store of future purchasing power. So, it is foolhardy to save money.”
- Lee Quaintance and Paul Brodsky, ‘Macro Polo’, January 2013.
The downfall of the Western financial system began during an episode of Bonanza. Speaking to the American nation on television on 15 August 1971, interrupting the popular western series in the process, President Nixon announced that the US dollar would “temporarily” no longer be convertible into gold.
(The temporary prohibition lasts to this day.)
For nearly 30 years leading up to that announcement, a system known as Bretton Woods had fixed the value of foreign currencies to the US dollar, and pegged the US dollar itself to the price of gold, at an exchange rate of $35 per ounce. But by 1971, the US government was en route to bankruptcy, courtesy of a guns and butter economic policy initiated by the earlier President Lyndon Johnson, who had landed America with the costs not just of a Great Society welfare programme, but of the Vietnam War into the bargain. Foreign countries, not least the French, were queuing up to exchange their increasingly worthless dollars for gold. The run on the US’ gold reserves had begun.
By removing its last links with gold, and slamming shut the window where currency could be exchanged for gold, Nixon was effectively devaluing the dollar. But by removing any practical constraints to the printing of dollars, Nixon also ushered in a period for the unrestrained creation of credit. If the US government was unable to balance its budget through tax revenues, it could simply print dollars to its heart’s content to make up the shortfall. And the US government has been no slouch when it comes to money printing ever since.
By closing the gold window, the US government consciously removed the brake restraining the Fed from money creation without limit. The Fed was given the very tools that, if abused, would bring down the system. In the aftermath of the so-called Nixon Shock, governments and central banks around the world, with their own currencies no longer pegged to the dollar, have enjoyed a similar privilege. 1971 marked the start of the world’s biggest ever orgy of debt. It was a starting gun for what will ultimately prove an economic race to the bottom.
Debt: the piper asks for payment
Since 1971, when President Nixon untethered the dollar from its last moorings to gold, total credit market debt owed in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by 54 times.
To put it another way, in the US, total debt doubled during the 1970s. By the early 1980s it had doubled again. By 1990 it had doubled once more. Total US debt had doubled again by 2000.
Between 2000 and 2010 it doubled yet again. This situation is shown in Table 1.
Table 1. Total US debt($ trillions) and time between doublings of debt in calendar quarters
Start End $ Trillions Quarters
Jan 1971 Oct 1977 3.29 27
Oct 1977 Oct 1983 6.47 24
Oct 1983 Jan 1990 13.1 25
Jan 1990 April 2000 26.2 41
April 2000 Jan 2009 52.9 34
In the words of Detlev Schlichter,
“The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.”
Since President Nixon took the US dollar off gold in 1971, we have had five decades of unbacked, state money, globally.
Governments have reacted to this new-found monetary freedom precisely as you would expect. We have had limitless money creation, limitless bank credit creation, limitless deficit spending.
Until now.
In the United States, total credit market debt has doubled five times over the course of over four decades. Everything that we know about the economy’s behaviour was learned during a period when credit doubled, on average, every 30 quarters. Every dollar that circulates in the US was loaned into existence by a bank, with interest. The interest can only be paid from further loans. Every year, the money supply must expand by an amount at least equal to the interest charges on all past money borrowed into existence, or the banking system will start to display extreme stress.
Our debt-based monetary system has a fatal flaw. As debts are created through loan origination, additional obligations arise in the form of interest payments. As a result, there can never be enough money to service debt obligations unless the stock of debt is continually expanded. When the costs of interest payments exceed growth in debt, marginal debtors can no longer afford to maintain their debt payments, and must begin liquidating.
The system reaches its terminal point when new debt creation fails to match existing interest charges. As soon as that point is reached, defaults will spiral through the system. Which is why the world’s central banks are doing everything in their power to keep the debt creation bandwagon on the road.
Why is this process destined to fail? Because nothing can expand forever. Money and debt have been growing at exponential rates, but they cannot do so indefinitely. The system can only hold together with perpetual economic growth. The last five decades of debt accumulation are not the steps towards some form of equilibrium, but rather the calm before the storm; acceleration towards huge disequilibrium. A lot of what we think of as wealth is going to vanish. Claims upon it are too numerous and future growth is almost destined to disappoint.
A journey to the outer limits
In the aftermath of the Global Financial Crisis, a story somehow got about that governments had started to whittle down that mountain of debt. That they had, in financial parlance, started to delever – i.e. pay down their accumulated debts. But as the McKinsey Global Institute pointed out in their research note of February 2015, ‘Debt and (not much) deleveraging’, the idea of governments suddenly becoming fiscally responsible after the Crash was a complete myth. The terrible reality is that in the years following 2007, global debt levels actually grew by some $57 trillion. Since the global debt mountain was already unpayable back in 2007, the fact that it has subsequently expanded, and not shrunk, should serve as a warning – to governments and investors alike. And then came Covid, lockdowns and furloughs..
Having belatedly woken up to the perilous lack of solvency throughout the financial system (governments and banks complicit both), central banks are now seemingly committed to a policy of permanent money creation and currency devaluation that threatens to impoverish everyone if it gets out of hand. Which it inevitably will.
We have no choice but to use government money. US banknotes, for example, technically Federal Reserve Notes, bear the wording
“This note is legal tender for all debts, public and private.”
No other form of money is accorded that status. As savers and investors we are thus forced to play an inflationary game not of our own making, using rules designed by politicians and the banking lobby to dispossess us of our true wealth. The latest iteration of this long con is the currency depreciation that comes with quantitative easing (a polite term for money printing), the sole purpose of which is to refloat a sunk banking sector by instilling illusory faith in the buoyancy of asset prices. As the British economist John Maynard Keynes said, the process of currency debauchery
“engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Sound money matters – without it, a stable economy is merely wishful thinking. Without sound money that retains its purchasing power over time, the owners of capital are discouraged from saving, and all investors are caught up in a desperate race against inflation that they cannot ultimately win. In a 2011 speech, Alasdair Macleod summarised the importance of a stable monetary system:
“I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation.
“Those who are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it. Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual’s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property.
“Sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.”
Much of the damage to the financial infrastructure underpinning US – and, in turn, global – monetary stability took place on Alan Greenspan’s watch. It was Greenspan who, in the aftermath of the dotcom bust, practically drowned asset markets with a tidal wave of liquidity and easy money. It was Greenspan who drove the Federal funds rate – the rate charged by US banks for lending to their peers – down to I% in 2003-2004, a four-decade low.
And it was Greenspan who opened the floodgates of liquidity that might have saved the US equity market for a time, but that also triggered an unsustainable boom in government and corporate debt, residential property, and a grotesque carnival of mortgage lending unimpaired by anything approaching prudence.
The post-millennial stock market rescue was not the only time Greenspan stepped in to save Wall Street. He has form as a serial inflationist, willing to slash interest rates to bail out investors who should not need rescuing from themselves: one thinks of the stock market crash of October 1987; the Savings and Loan crisis; the Asian crisis; the collapse of hedge fund Long-Term Capital Management; the feared Y2K crisis. No central banker has done more for the concept of moral hazard – the risk that the perceived support of the monetary authorities will cause financial institutions to play fast and loose with other people’s money.
But Greenspan himself somehow managed to dodge the bullet.
It would fall to his successor, Ben Bernanke, to take it.
Markets reach their tipping point
Economists sometimes talk of something called a Minsky moment.
Named after Dr. Hyman Minsky, the Minsky moment is the market correction that ensues after a long period of apparent stability and prosperity. The prosperity and the characteristics of an asset boom lead to heightened speculation using borrowed money. By way of example, consider the easy credit environment of the Roaring Twenties leading up to the Great Crash of 1929.
As speculators amassed ever-larger debts to fuel their addiction to seemingly easy profits, they experienced ever-greater demands on their cash flows. As the debt monster demanded to be fed, it ultimately consumed everything – and still wanted more. Losses from speculators led to growing instances of forced selling, which in turn forced lenders to call in their loans – and fresh waves of involuntary selling began. The market started to eat itself, and collapsed from within. With nobody left to bid for distressed assets, prices started to gap down in an increasingly disorderly manner. Market liquidity evaporated, and everybody wanted cash.
An analogy with the US authorities’ handling of forest fires may be useful. In the 1960s and 1970s, Midwestern American states fell victim to scores of wildfires and the US Forest Service used to try to put out these forest fires whenever they arose. These constant interventions by the US Forest Service appeared to have little positive impact – if anything, the problems seemed to worsen.
Over time, foresters came to appreciate that fires were a normal and healthy element of the forest ecosystem. Naturally occurring fires are necessary to remove old forest cover, underbrush and debris. If they are suppressed, the inevitable conflagration to come has a far greater store of latent fuel at its disposal. By continually suppressing small fires, the US Forest Service was unwittingly creating the conditions for larger and less containable wildfires in the future. They had inadvertently allowed a gigantic build-up of latent fuel that ultimately meant that ‘the Big One’, when it finally came, would be super-destructive.
In continuingly suppressing smaller outbreaks of financial instability or market volatility by means of drowning them with surplus liquidity, the monetary authorities inadvertently stored up a growing pile of combustible dry tinder. During the regime of the Greenspan put, numerous small fires in the market – including the 1987 Crash, the failure of Long-Term Capital Management, the non-event of the Y2K crisis, and the dotcom bust – were doused with easy money. Notwithstanding these interventions, equity market investors still endured two separate bear markets after the year 2000 that saw market valuations halve. Perhaps the mainstream policy response to any hint of likely economic hardship should not simply be to slash interest rates, in the same way that the best response to recalcitrant children should not simply be to smother them with sweets. The tirade will be all the stronger when the sugar wears off. As the philosopher Karl Popper said,
“In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable.”
Central bank monetary planning is the glaring hole at the centre of modern economics. We accept (or should do) that the modern economic world is highly complex, with practically infinite interactions between countries, governments, exchange rates, interest rates, stock markets, corporations, households, entrepreneurs, and consumers. In most areas we also accept that free markets are perfectly capable of driving Adam Smith’s invisible hand to ensure that enlightened self-interest benefits the many as opposed to the few. Despite this, the idea that one institution – the central bank- is even capable of mastering such complexity and fine-tuning the workings of a highly complex economy through the brute mechanism of dictating the price of money has rarely been brought into question.
The 1810 Bullion Committee in Britain, however, acknowledged that economic central planning was impossible:
“The most detailed knowledge of the actual trade of a country, combined with the profound Science in all the principles of Money and circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.”
The investor Charles Gave suggests that the role of economists, along with that of governments and central banks, should be to promote a stable monetary and legal framework for risk-takers (the likes of entrepreneurs and money managers) to make their decisions as rationally as they can.
“Unfortunately, this has not happened. Instead, in a new and improved declination of Friedrich Hayek’s ‘fatal conceit’, we seem to be moving away from ‘scientific socialism’ to ‘scientific capitalism’ – where the overconfident and overeducated control-engineers are no longer members of the avant-garde of the proletariat, but plain, boring and well-meaning economists working in the entrails of the world’s central banks. My intent is not to show why these economists will fail (bigger and brighter minds such as Hayek, Mises, Friedman, etc. have already done this) – but rather to review the impact that the misguided manipulation of the price of money (exchange and interest rates) is having on the notion of risk.”
As a direct consequence of the central bank manipulation of asset prices, today’s markets give the impression of risklessness, irrespective of price. Why not buy conspicuously overpriced bonds if you know there is a greater fool out there, in the form of a central banker willing to pay even more for those bonds than you did? After all, the central bank can print money out of thin air to make those purchases. This must end badly: major financial accidents are typically born out of a misconception of risks, rather than returns. Building a rational portfolio, where risks can be appropriately hedged, is almost impossible when market signals have effectively disappeared.
The West’s decision to steal Russia’s foreign reserves after the 2022 invasion of Ukraine represented a nail in the coffin of the unipolar petrodollar, given that those reserves will have included US dollars and US Treasury bonds, issued by a sovereign at least $38 trillion in debt. That decision confirmed – if confirmation were needed – that the US was an untrustworthy political and monetary ally (‘our currency – but your problem’). The most recent adventuring in Iran by Trump Administration 2.0 has reconfirmed that thesis. Jim Rickards, in his 2014 book ‘The Death of Money: the coming collapse of the international monetary system’ makes the following observation:
“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
When ? Now. At what cost ? Ask those investors sheltering in the confines of fiat currency. Then ask those investors holding stateless assets such as gold and silver.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:
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…………
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and real assets, and also in systematic trend-following funds.
“The best things in life are free
But you can give them to the birds and bees
I want money
That’s what I want
That’s what I want
That’s what I want.”
Get your Free
financial review
Our monetary system is dying.
According to the definitions of traditional economics, to qualify as money, whatever we use as money has to have three characteristics. It acts as a medium of exchange; i.e. we can use it to purchase goods and services without resorting to the cruder exchange represented by bartering. It acts as a unit of account, i.e. we can price things with varying degrees of value with it. And it acts as a store of value; i.e. we can choose to defer present spending and save using it – it retains our purchasing power over the longer term.
Over time, mankind has used all kinds of things as money, including cattle, shells, nails, tobacco, cotton, silver and gold.
“In the most developed societies, the precious metals have eventually been preferred to all other goods because their physical characteristics (scarcity, durability, divisibility, distinct look and sound, homogeneity through space and time, malleability, and beauty) make them particularly suitable to serve in this function.”
Paper money itself is a comparatively recent phenomenon – it came about after medieval merchants realised that carrying gold receipts was more practical and convenient than carrying physical bullion. These days, our money is almost comically insubstantial.
Less than 8% of all dollars are in the form of paper money or coins. Most dollars exist in purely electronic form. Paper money itself is an abstraction. Given that most of it has no physical form, it is what Satyajit Das calls the abstraction of an abstraction. It exists solely to act as a medium of exchange. There are no limits to the amount of money that can be created.
To make it clear, unbacked paper (or fiat – paper money made legal tender by government decree) is a distinctly modern experiment. It is not an experiment that is likely to end well, since in the entire history of humankind, no unbacked paper currency has ever lasted. They have all reverted to their intrinsic value, which, as Voltaire reminds us, is zero.
The modern banking system operates on what is called a fractional reserve basis: only a fraction of a bank’s deposits are kept as liquid reserves. The vast majority of deposits are lent out, re-deposited, and re-lent elsewhere. This mechanism normally works tolerably well, though in the event of a systemic loss of confidence, it has the unfortunate side-effect of bank runs.
There is one further huge side-effect of fiat money and fractional reserve banking: inflation. Monetary purists point out that inflation is not just defined as a generalised rise in the prices of goods and services – rather, it is the rise in the money supply that tends to ignite the rising prices that follow in its wake. To generate inflation, in other words, merely let politicians and central bankers print money and let their banker friends create more.
As the investment managers Lee Quaintance and Paul Brodsky describe it, money, per se, is base money (a measure known by economists as M0), which may only be created by central banks.
It is comprised of physical currencies in circulation and bank reserves held on deposit at central banks. Presently, there are nowhere near enough bank reserves to cover bank deposits (US bank deposits, for example, are unreserved by over 7:1). There is no need to fear bank runs, however. Were every bank depositor in the world to suddenly demand his or her money, central banks could easily create it with a few keystrokes. Herein lies a critical problem: central banks can easily create base money ex nihilo.
It requires no form of discipline or labour whatsoever. Central banks, in other words, have developed precisely the tools that will cause them to destabilise the global monetary system while they claim to be its saviours.
Government-sponsored paper money, in conjunction with fractional reserve banking, is inherently inflationary. Former US Federal Reserve chairman Alan Greenspan admitted as much when he acknowledged in 2005 that “we can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.” In other words, central bankers can print as much money as you want – just don’t expect it, over time, to be worth anything.
“Modern money is satisfying the requirements as units of account and media of exchange, but not the requirement as a store of future purchasing power. So, it is foolhardy to save money.”
The downfall of the Western financial system began during an episode of Bonanza. Speaking to the American nation on television on 15 August 1971, interrupting the popular western series in the process, President Nixon announced that the US dollar would “temporarily” no longer be convertible into gold.
(The temporary prohibition lasts to this day.)
For nearly 30 years leading up to that announcement, a system known as Bretton Woods had fixed the value of foreign currencies to the US dollar, and pegged the US dollar itself to the price of gold, at an exchange rate of $35 per ounce. But by 1971, the US government was en route to bankruptcy, courtesy of a guns and butter economic policy initiated by the earlier President Lyndon Johnson, who had landed America with the costs not just of a Great Society welfare programme, but of the Vietnam War into the bargain. Foreign countries, not least the French, were queuing up to exchange their increasingly worthless dollars for gold. The run on the US’ gold reserves had begun.
By removing its last links with gold, and slamming shut the window where currency could be exchanged for gold, Nixon was effectively devaluing the dollar. But by removing any practical constraints to the printing of dollars, Nixon also ushered in a period for the unrestrained creation of credit. If the US government was unable to balance its budget through tax revenues, it could simply print dollars to its heart’s content to make up the shortfall. And the US government has been no slouch when it comes to money printing ever since.
By closing the gold window, the US government consciously removed the brake restraining the Fed from money creation without limit. The Fed was given the very tools that, if abused, would bring down the system. In the aftermath of the so-called Nixon Shock, governments and central banks around the world, with their own currencies no longer pegged to the dollar, have enjoyed a similar privilege. 1971 marked the start of the world’s biggest ever orgy of debt. It was a starting gun for what will ultimately prove an economic race to the bottom.
Debt: the piper asks for payment
Since 1971, when President Nixon untethered the dollar from its last moorings to gold, total credit market debt owed in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by 54 times.
To put it another way, in the US, total debt doubled during the 1970s. By the early 1980s it had doubled again. By 1990 it had doubled once more. Total US debt had doubled again by 2000.
Between 2000 and 2010 it doubled yet again. This situation is shown in Table 1.
Table 1. Total US debt($ trillions) and time between doublings of debt in calendar quarters
Start End $ Trillions Quarters
Jan 1971 Oct 1977 3.29 27
Oct 1977 Oct 1983 6.47 24
Oct 1983 Jan 1990 13.1 25
Jan 1990 April 2000 26.2 41
April 2000 Jan 2009 52.9 34
In the words of Detlev Schlichter,
“The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.”
Since President Nixon took the US dollar off gold in 1971, we have had five decades of unbacked, state money, globally.
Governments have reacted to this new-found monetary freedom precisely as you would expect. We have had limitless money creation, limitless bank credit creation, limitless deficit spending.
Until now.
In the United States, total credit market debt has doubled five times over the course of over four decades. Everything that we know about the economy’s behaviour was learned during a period when credit doubled, on average, every 30 quarters. Every dollar that circulates in the US was loaned into existence by a bank, with interest. The interest can only be paid from further loans. Every year, the money supply must expand by an amount at least equal to the interest charges on all past money borrowed into existence, or the banking system will start to display extreme stress.
Our debt-based monetary system has a fatal flaw. As debts are created through loan origination, additional obligations arise in the form of interest payments. As a result, there can never be enough money to service debt obligations unless the stock of debt is continually expanded. When the costs of interest payments exceed growth in debt, marginal debtors can no longer afford to maintain their debt payments, and must begin liquidating.
The system reaches its terminal point when new debt creation fails to match existing interest charges. As soon as that point is reached, defaults will spiral through the system. Which is why the world’s central banks are doing everything in their power to keep the debt creation bandwagon on the road.
Why is this process destined to fail? Because nothing can expand forever. Money and debt have been growing at exponential rates, but they cannot do so indefinitely. The system can only hold together with perpetual economic growth. The last five decades of debt accumulation are not the steps towards some form of equilibrium, but rather the calm before the storm; acceleration towards huge disequilibrium. A lot of what we think of as wealth is going to vanish. Claims upon it are too numerous and future growth is almost destined to disappoint.
A journey to the outer limits
In the aftermath of the Global Financial Crisis, a story somehow got about that governments had started to whittle down that mountain of debt. That they had, in financial parlance, started to delever – i.e. pay down their accumulated debts. But as the McKinsey Global Institute pointed out in their research note of February 2015, ‘Debt and (not much) deleveraging’, the idea of governments suddenly becoming fiscally responsible after the Crash was a complete myth. The terrible reality is that in the years following 2007, global debt levels actually grew by some $57 trillion. Since the global debt mountain was already unpayable back in 2007, the fact that it has subsequently expanded, and not shrunk, should serve as a warning – to governments and investors alike. And then came Covid, lockdowns and furloughs..
Having belatedly woken up to the perilous lack of solvency throughout the financial system (governments and banks complicit both), central banks are now seemingly committed to a policy of permanent money creation and currency devaluation that threatens to impoverish everyone if it gets out of hand. Which it inevitably will.
We have no choice but to use government money. US banknotes, for example, technically Federal Reserve Notes, bear the wording
“This note is legal tender for all debts, public and private.”
No other form of money is accorded that status. As savers and investors we are thus forced to play an inflationary game not of our own making, using rules designed by politicians and the banking lobby to dispossess us of our true wealth. The latest iteration of this long con is the currency depreciation that comes with quantitative easing (a polite term for money printing), the sole purpose of which is to refloat a sunk banking sector by instilling illusory faith in the buoyancy of asset prices. As the British economist John Maynard Keynes said, the process of currency debauchery
“engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Sound money matters – without it, a stable economy is merely wishful thinking. Without sound money that retains its purchasing power over time, the owners of capital are discouraged from saving, and all investors are caught up in a desperate race against inflation that they cannot ultimately win. In a 2011 speech, Alasdair Macleod summarised the importance of a stable monetary system:
“I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation.
“Those who are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it. Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual’s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property.
“Sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.”
Much of the damage to the financial infrastructure underpinning US – and, in turn, global – monetary stability took place on Alan Greenspan’s watch. It was Greenspan who, in the aftermath of the dotcom bust, practically drowned asset markets with a tidal wave of liquidity and easy money. It was Greenspan who drove the Federal funds rate – the rate charged by US banks for lending to their peers – down to I% in 2003-2004, a four-decade low.
And it was Greenspan who opened the floodgates of liquidity that might have saved the US equity market for a time, but that also triggered an unsustainable boom in government and corporate debt, residential property, and a grotesque carnival of mortgage lending unimpaired by anything approaching prudence.
The post-millennial stock market rescue was not the only time Greenspan stepped in to save Wall Street. He has form as a serial inflationist, willing to slash interest rates to bail out investors who should not need rescuing from themselves: one thinks of the stock market crash of October 1987; the Savings and Loan crisis; the Asian crisis; the collapse of hedge fund Long-Term Capital Management; the feared Y2K crisis. No central banker has done more for the concept of moral hazard – the risk that the perceived support of the monetary authorities will cause financial institutions to play fast and loose with other people’s money.
But Greenspan himself somehow managed to dodge the bullet.
It would fall to his successor, Ben Bernanke, to take it.
Markets reach their tipping point
Economists sometimes talk of something called a Minsky moment.
Named after Dr. Hyman Minsky, the Minsky moment is the market correction that ensues after a long period of apparent stability and prosperity. The prosperity and the characteristics of an asset boom lead to heightened speculation using borrowed money. By way of example, consider the easy credit environment of the Roaring Twenties leading up to the Great Crash of 1929.
As speculators amassed ever-larger debts to fuel their addiction to seemingly easy profits, they experienced ever-greater demands on their cash flows. As the debt monster demanded to be fed, it ultimately consumed everything – and still wanted more. Losses from speculators led to growing instances of forced selling, which in turn forced lenders to call in their loans – and fresh waves of involuntary selling began. The market started to eat itself, and collapsed from within. With nobody left to bid for distressed assets, prices started to gap down in an increasingly disorderly manner. Market liquidity evaporated, and everybody wanted cash.
An analogy with the US authorities’ handling of forest fires may be useful. In the 1960s and 1970s, Midwestern American states fell victim to scores of wildfires and the US Forest Service used to try to put out these forest fires whenever they arose. These constant interventions by the US Forest Service appeared to have little positive impact – if anything, the problems seemed to worsen.
Over time, foresters came to appreciate that fires were a normal and healthy element of the forest ecosystem. Naturally occurring fires are necessary to remove old forest cover, underbrush and debris. If they are suppressed, the inevitable conflagration to come has a far greater store of latent fuel at its disposal. By continually suppressing small fires, the US Forest Service was unwittingly creating the conditions for larger and less containable wildfires in the future. They had inadvertently allowed a gigantic build-up of latent fuel that ultimately meant that ‘the Big One’, when it finally came, would be super-destructive.
In continuingly suppressing smaller outbreaks of financial instability or market volatility by means of drowning them with surplus liquidity, the monetary authorities inadvertently stored up a growing pile of combustible dry tinder. During the regime of the Greenspan put, numerous small fires in the market – including the 1987 Crash, the failure of Long-Term Capital Management, the non-event of the Y2K crisis, and the dotcom bust – were doused with easy money. Notwithstanding these interventions, equity market investors still endured two separate bear markets after the year 2000 that saw market valuations halve. Perhaps the mainstream policy response to any hint of likely economic hardship should not simply be to slash interest rates, in the same way that the best response to recalcitrant children should not simply be to smother them with sweets. The tirade will be all the stronger when the sugar wears off. As the philosopher Karl Popper said,
“In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable.”
Central bank monetary planning is the glaring hole at the centre of modern economics. We accept (or should do) that the modern economic world is highly complex, with practically infinite interactions between countries, governments, exchange rates, interest rates, stock markets, corporations, households, entrepreneurs, and consumers. In most areas we also accept that free markets are perfectly capable of driving Adam Smith’s invisible hand to ensure that enlightened self-interest benefits the many as opposed to the few. Despite this, the idea that one institution – the central bank- is even capable of mastering such complexity and fine-tuning the workings of a highly complex economy through the brute mechanism of dictating the price of money has rarely been brought into question.
The 1810 Bullion Committee in Britain, however, acknowledged that economic central planning was impossible:
“The most detailed knowledge of the actual trade of a country, combined with the profound Science in all the principles of Money and circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.”
The investor Charles Gave suggests that the role of economists, along with that of governments and central banks, should be to promote a stable monetary and legal framework for risk-takers (the likes of entrepreneurs and money managers) to make their decisions as rationally as they can.
“Unfortunately, this has not happened. Instead, in a new and improved declination of Friedrich Hayek’s ‘fatal conceit’, we seem to be moving away from ‘scientific socialism’ to ‘scientific capitalism’ – where the overconfident and overeducated control-engineers are no longer members of the avant-garde of the proletariat, but plain, boring and well-meaning economists working in the entrails of the world’s central banks. My intent is not to show why these economists will fail (bigger and brighter minds such as Hayek, Mises, Friedman, etc. have already done this) – but rather to review the impact that the misguided manipulation of the price of money (exchange and interest rates) is having on the notion of risk.”
As a direct consequence of the central bank manipulation of asset prices, today’s markets give the impression of risklessness, irrespective of price. Why not buy conspicuously overpriced bonds if you know there is a greater fool out there, in the form of a central banker willing to pay even more for those bonds than you did? After all, the central bank can print money out of thin air to make those purchases. This must end badly: major financial accidents are typically born out of a misconception of risks, rather than returns. Building a rational portfolio, where risks can be appropriately hedged, is almost impossible when market signals have effectively disappeared.
The West’s decision to steal Russia’s foreign reserves after the 2022 invasion of Ukraine represented a nail in the coffin of the unipolar petrodollar, given that those reserves will have included US dollars and US Treasury bonds, issued by a sovereign at least $38 trillion in debt. That decision confirmed – if confirmation were needed – that the US was an untrustworthy political and monetary ally (‘our currency – but your problem’). The most recent adventuring in Iran by Trump Administration 2.0 has reconfirmed that thesis. Jim Rickards, in his 2014 book ‘The Death of Money: the coming collapse of the international monetary system’ makes the following observation:
“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
When ? Now. At what cost ? Ask those investors sheltering in the confines of fiat currency. Then ask those investors holding stateless assets such as gold and silver.
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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and real assets, and also in systematic trend-following funds.
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