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How the Monetary System Really Works and What It Means for Your Money

Wealth Cycles 
AUG 11, 2016

*Editor's Note: In 2010, Mike Maloney and a team of analysts wrote a financial education series called Wealth Cycles. Although this series is no longer available to the public, we dug into our archives to bring it back.

You’ll find the lessons and historical perspectives in these articles to be as relevant today as they were when they were first published. As Mike has stated many times, understanding history and educating yourself on the basics of economics will prepare you for what’s ahead and help you achieve true prosperity.

Going forward, we'll publish the Wealth Cycles series when appropriate, so keep an eye out. This first article sets the stage for why we think gold and silver will ultimately end in a mania. Enjoy.

Wealth Cycles  |  Volume 1, Issue 1

“It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” -- Henry Ford, Founder, Ford Motor Co.

When most people deposit a paycheck or make an IRA contribution, they see money going into their account.

But we see something different. We see billions of hardworking people filling their savings and retirement accounts with currency.

Currency is created by the network of mints, central banks, and governments that make up the global monetary system. Just about every transaction around the world involves an exchange of currency of some kind. Dollars, Euros, Yen, you name it.

That’s why most people believe currency is money. But it’s not. In reality, all currencies in the world today are fiat.

Fiat is just a fancy word that means a currency is officially printed and accepted by a government. It’s like a symbol of authenticity. Much like the shiny “genuine merchandise” stickers stuck to brand new Major League Baseball caps, except someday those might actually be worth more.

Fiat currencies only have value because the governments who print them say they do. Of course, there’s an underlying demand for fiat currency because governments require citizens and companies to pay taxes to them in their official currency. So just about everyone needs it.

But other than that, fiat currencies have no intrinsic value. They are official sheets of paper. Technically, they’re worthless. Fiat currencies can’t be redeemed for gold or silver. 

And because of that, all fiat currencies lose value.

But it wasn’t always this way. Which may be why most people believe their currency, their life’s savings, hold value.

Before Our All-Fiat Currency System

Once upon a time, the U.S. dollar and many of the other currencies derived their value from the gold stored in national treasuries. In effect, each unit of currency was a sort of IOU to the holder, signifying it was backed by a like amount of gold.

As Mike described in his book, Guide to Investing in Gold and Silver, before the Federal Reserve was created, each U.S. Treasury note (paper dollar) was fully backed by gold or silver. When the Federal Reserve Act was passed in 1913, the amount of gold backing each dollar was reduced to just 40% of the face value of existing currency. In effect, this allowed the U.S. government to increase the amount of currency it could create and spend by 60%, enabling deficit spending for World War I and the accompanying increase of the currency supply.

Then, in 1934, the U.S. government devalued the dollar by 41% by raising the price of gold from $20.67 per ounce—the price established way back in 1834—to $35. This revaluation of the dollar raised the value of the gold held at the U.S. Treasury, so that it once again matched the total value of base money, or all the dollars then in circulation. In effect, the U.S. dollar was once again fully backed by gold.

Under the Bretton Woods system, the U.S. dollar was designated the world’s reserve currency. Most other nations pegged their currencies to the dollar, and the U.S. in return agreed to redeem U.S. dollars in gold at the rate of $35. Under Bretton Woods, the world essentially was on the “Dollar Standard.”

But it turned out the Bretton Woods system was not up to the complexities of a modern global economy. The currency supply was once again inflated to fund WWII, Korea, Vietnam, and President Lyndon B. Johnson’s social programs. America’s foreign policy increasingly meant spending lots of dollars in other countries on foreign aid, defense and military spending, and international investment and trade. As a result, lots more dollars flowed into the treasuries of other nations, and much less capital flowed back into the U.S. Treasury, resulting in imbalances.

From the 1950s on, the U.S. government and the Fed undertook a series of interventions in the free market designed to bring the U.S. monetary system back into balance. As always ultimately happens whenever authorities interfere with the workings of the free market, for every action taken there are unintended and usually destructive consequences.

Long term interest rates kept artificially low encouraged foreign borrowing and discouraged domestic investment. French President Charles de Gaulle opposed the use of the dollar as the world’s reserve currency. So France began buying up dollars and redeeming them in gold, seriously depleting the supply of gold in the U.S. Treasury.

As described by “By the end of the 1960s, it was clear that the ills plaguing the international monetary system and the American dollar would have to be addressed at a basic level. The Kennedy and Johnson Administrations had applied solutions to the mounting balance of payments crisis that were at best patch-up jobs, postponements of the inevitable. The balance of payments was off balance, the dollar was overvalued, inflation was picking up speed, and the United States could do little to restore economic order without compromising major aspects of domestic and foreign policy.”

In the end, the United States was not able to meet its commitment to the rest of the world under the Bretton Woods system and keep the U.S. dollar pegged to gold at the rate of $35 per ounce. The bottom line is that Bretton Woods did not allow the United States the “flexibility”—the ability to create as much currency as it needed—to fund its foreign and domestic policy goals.

By 1971, the United States was essentially bankrupt; it did not have enough gold in the Treasury to redeem all the dollars in circulation.

That year, President Nixon severed the link between the U.S. dollar and gold. With his act, in effect, every currency in the world—thanks to the dollar’s status as the world’s reserve currency—became fiat currency.

A currency is fiat if it is not backed by gold or any other asset. The only thing backing fiat currency is faith. As Michael Maloney wrote in his book:

“A fiat is an arbitrary decree, order, or pronouncement given by a person, group, or body with the absolute authority to enforce it. A currency that derives its value from declaratory fiat or an authoritative order of the government is by definition a fiat currency.”

Now unencumbered by U.S. and world monetary policy, the free market bid the price of gold up to $850 per ounce in 1980. At that point the value of the gold held at the U.S. Treasury exceeded the total value of base money—the total of dollars in circulation—plus all the dollars existing in the form of outstanding revolving credit.

We measure the amount of currency in circulation by adding the number of dollars in circulation and in bank reserves (base money) to the total of dollars represented by outstanding revolving credit, which is mostly in the form of unpaid credit card balances. We include credit card purchases because when you charge a purchase to your credit card, in effect new currency is created in the amount of your charge. That new currency stays in circulation until you pay off your credit card balance. More consumers use credit cards as a medium of exchange instead of cash, and so the digital equivalent of cash must be included in our modern day monetary system.

The Shaky Foundation of Our Modern Monetary System

In all likelihood, 99% of the world’s population doesn’t understand the shaky ground on which the world’s monetary system—our fiat currency system—rests. Many people still believe the U.S. dollar is backed by the gold sitting in the vault at Fort Knox. Most have no idea that the only thing backing every currency in the world right now (including the U.S. dollar) is debt and the solemn promise of each government to tax its citizens in the future to pay that debt. In the United States, this promise is called a Treasury bond.

“Should government refrain from regulation (taxation), the worthlessness of the money becomes apparent and the fraud can no longer be concealed.”-- John Maynard Keynes in Consequences of Peace

Meanwhile, the currency wars continue, as nations continually devalue their own currencies in order to keep them low in relation to the dollar. Every country wants a weaker currency because it helps their exports and GDP figures. By weakening their currencies, governments are able to keep the prices of their goods low, making them more attractive to foreign buyers. The United States’ devaluation of the dollar via currency creation in effect forces other nations to devalue their currencies as well. It’s upside down, but it is political death to have a strengthening national currency in a world of fiat currency debasement.

But currency wars are not consequence free. Check out what Belgian economist Robert Triffin describes about the growing international conflict over monetary policy…

“Consider, for instance, the tension between emerging economies’ demand for reserves and their fear that the main reserve currency, the dollar, may lose value—a dilemma first noted in 1947 by Robert Triffin, a Belgian economist. When the world relies on a single reserve currency, Triffin argued, that currency’s home country must issue lots of assets (usually government bonds) to lubricate global commerce and meet the demand for reserves. But the more bonds it issues, the less likely it will be to honor its debts. In the end, the world’s insatiable demand for the “risk free” reserve asset will make that asset anything but risk free. As an illustration of the modern thirst for dollars, the IMF reckons that at the current rate of accumulation global reserves would rise from 60% of American GDP today to 200% in 2020 and nearly 700% in 2035.” -- The Economist

The world economy is at the brink of a deflationary spiral. Governments and central banks are taking desperate measures, flooding the global economy with currency in the form of stimulus packages, bailouts, deficit spending, cheap credit, and negative rates, all in an effort to ward off deflation.

The problem is, as growth stagnates and declines, paying off the debt will become impossible. The strength of the U.S. economy and its financial standing are shakier than at any other time in history. The national debt is now $19.4 trillion, with total US debt over $66 trillion. Throw in unfunded liabilities, such as Social Security and Medicare, and the total reaches a whopping $103 trillion. These figures are not sustainable, nor repayable!

Gold Will Be the Center of the Wealth Transfer

Although we have no empirical data before the establishment of the U.S. Federal Reserve, it appears that the free market has periodically revalued gold—increasing its value to account for the excess currency in circulation—time after time, for the past 2,400 years.

This lesson from history tell us that the free market will bid up the price of gold until the value of the gold is once again in equilibrium with the value of circulating currency. And with a world economy more interconnected than ever before, and with every currency in the world now fiat, we can expect the free market to push gold prices high enough to account for all currency now in circulation around the world. If this happens, it will be nothing unusual… just be history repeating itself.

In the long run, inflation is inevitable, as governments and central banks continue implementing inflationary policies to lower the cost of debt, avoid deflation, and stimulate their economies. The more currency floating around, the higher the price of gold and silver will ultimately rise. That’s because throughout history, every time a nation has debased and finally destroyed its currency, the free market has chosen gold and silver as the ideal money.

But the massive expansion of currency supplies around the world has created conditions ripe for a currency crisis of massive proportions.

Ultimately, gold will not only benefit from the massive expansion of the currency supply, but it will also benefit from the global currency crisis that lies in wait.

During these upcoming crises, it is nearly certain that holders of gold and silver will be the beneficiaries of the wealth transfer that will occur as the entire globe rushes into the safe haven assets. The coming rush to precious metals will be a completely different type of bull market, because not only will you get the buyers looking for opportunity, but panicked investors trying to salvage their wealth.

The coming monetary crisis will offer an once-in-a-lifetime opportunity that will benefit from both fear and greed at the same time. In fact, I believe it will be the greatest opportunity in history.

Gold and silver rising in value against fiat currencies is inevitable. As Mike stated in his book, “it is as certain as the sunrise.”