Veritas: A failed 40-year experiment in fiat money

As markets eagerly await guidance today on whether Ben Bernanke, Chairman of America’s Federal Reserve, will start printing more dollars, we print below a useful longer term perspective on fiat currencies from Nick Barisheff, president and CEO of Bullion Management Group, www.bmgbullion.com, in Canada.

 

Monday, August 15 marked the fortieth anniversary of the US default on the dollar’s convertibility into gold.

It was the world’s de facto reserve currency and thus began an experiment with a reserve fiat currency that was doomed to failure before it began – because there has never been a successful fiat currency in all of history.

August 15, 1971 was just like any other day for most people, and President Nixon’s unprecedented decision to cut the US dollar’s gold international convertibility was largely ignored by the public. The majority of citizens didn’t understand the implications for their financial future.

Contrast that to today, where a historic downgrade of US debt and a very public $2trn increase of the debt ceiling dominated headlines and the television news.

Forty years later, it is a tale of contrasts between US dollars and gold.

The US dollar is the world’s reserve currency despite the fact that it is being issued by the world’s largest debtor nation. Investors around the world flee to it during times of crisis, despite it continually loses value through debasement.

Gold meanwhile is dismissed as a viable asset, ignored by most pensions, institutions and asset managers despite increasing from $35 in 1971 to over $1,800.

It is important to note that on this historic day 40 years ago, the dollar quietly ceased to be money and instantly became a currency.

Money and currency are often considered as one and the same; however, there are meaningful and significant differences between the two. While fiat currencies function well as a medium of exchange and a unit of account, they fail miserably as a store of value.

The US dollar has lost over 80% of its purchasing power compared to gold in the last decade alone.

Gold, however, has endured as money for over 3,000 years, and maintained its purchasing power throughout that time, because it meets all of the criteria for money.

To satisfy the functions of money, an item must be a unit of account, a medium of exchange and a store of value. Gold is all of these things; it is durable, portable, divisible, consistent, intrinsically valuable and, of crucial relevance today, it cannot be created by central banks.

Gold is a tangible asset, something that is real and in limited supply, as opposed to fiat currency, which is merely worthless paper that governments can produce at will. It is only the promise written on the paper enforced by a government decree that gives it any value. The more governments produce, the less value it has.

In light of this, it makes sense to earn currency and then protect its value through precious metals ownership of gold, silver and platinum.

The current monetary system, which, in its current form, began in 1971, has two critical features that have profound implications for our financial future. Fiat currency is created out of debt via the banking system and the Federal Reserve [and] the amount of currency created must continually expand.

There are limits to debt expansion, and it is my guess that we are now entering the phase where the compounding of the debt and the loss of our purchasing power is not only more noticeable, but also about to become exponential.

In three years time, it is quite possible that these numbers could be double what they are today.

Dr. Bartlett, an emeritus Professor of Physics at the University of Colorado, has said: “The greatest shortcoming of the human race is the inability to understand the exponential function.”

Until governments around the world stop spending beyond their means, running huge deficits, incurring massive debts and creating endless amounts of fiat currency, precious metals will continue to rise and fiat currency values will continue to erode.

The best way to protect portfolios and preserve wealth from this impending crisis is to own precious metals.

When we consider that total global financial assets are estimated at over $200trn, but total global above-ground gold bullion is a modest $3trn, and only growing by approximately $100bn a year, we can see that once a shift towards gold occurs, there will be too much paper currency chasing too little gold.

Of the $3trn of above-ground gold bullion, about half is owned by central banks and half is privately held. The central banks have been net buyers since 2009, and most of the privately held gold is not for sale at any price.
If only 5% of the $200trn in financial assets were to allocate to gold, there would be about $10trn trying to buy the $1.5trn of privately held gold bullion.

Under that scenario the price of gold will trade substantially higher than the levels today.

There have been suggestions in the media that holding gold is too risky. It has been called a useless, overvalued relic that pays no interest and is in a bubble. We heard this same rhetoric when gold was $300, then $500, $800, $1,000 and then at $1,800.

This advice has been costly to those who listened. In truth, gold is not rising; fiat currencies are falling and will continue to do so until governments around the world begin to act responsibly. There is nothing on the horizon to indicate this will happen any time soon.

It is difficult to predict how the financial mess the major economies of the world are in will unravel. Some economists believe the increase in money supply will have an inflationary effect, while others believe the lack of demand and lack of growth will result in deflation.

Federal Reserve Chairman Ben Bernanke made it quite clear in his famous “helicopter” speech that there will be no monetary deflation on his watch. Other historical examples indicate we will end up in a hyperinflation followed by a deflationary collapse.

The best defense in either eventuality, however, is to hold precious metals.

The lack of understanding in the difference between money and currencies is so pervasive that even Warren Buffett, who has received many accolades for his investment track record, has criticized gold in the past. In a speech to the 1998 Harvard graduating class he said: “Gold, It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In contrast to this view of gold, fiat currency is nothing more than a medium of exchange that is susceptible to abuse by the governments that produce it.

Trees are cut down, turned into paper, a number is written on it and by force it is declared legal tender. It is created out of thin air, backed by debt, printed without limit and its value decreases as the amount of printing increases.

There has never been a successful paper currency in history; the longest-standing currencies, the British pound and the US dollar, have both lost 99.5% of their purchasing power. Currency completely fails as a store of value. Anyone watching from Mars would be scratching their head at this, as well.

Perhaps the former chairman of the Federal Reserve, Alan Greenspan, explained the importance of the gold best when, in 1966, he said, “In the absence of the gold standard there is no way to protect savings from confiscation through inflation. There is no safe store of value.”

Forty years after President Nixon ended the dollar’s convertibility to gold; it seems that Mr. Greenspan was correct.

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