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The Daily Reckoning Weekend Edition Saturday, November 13, 2010 Buenos Aires, Argentina ------------------------------------------------------- Fiat currencies: impoverishing the world one idiotic policy at a time, World Bank president stirs up a hornet's nest with talk of golden anchor, Plus, all the reckonings from the past week neatly archived for your voluntary consumption... Joel Bowman, from Buenos Aires, Argentina... Investors, their stomachs in knots after a wild couple of weeks, want to know: Will Bernanke's magic potion of funny money be enough to support asset prices and, as he hopes, foster a new era of confidence and consumer spending? Can trillions of little green floating abstractions, anchored to nothing more than the promise of a few bureaucrats in stolen suits, actually make the world a richer place to live? Can meddling from central planners "save," as one commentator who clearly misunderstood the point of the whole exercise queried, "capitalism from itself?" Of course not! Haven't you been listening, Fellow Reckoner? Capitalism doesn't need to be saved...it needs to be left alone, free to work through the peaks and troughs of the natural business cycle in a measured, even-handed manner. The whole interventionalist game is pure hogwash, pinned on the ghost of a theory that history has shown to be a disastrous fraud every time it was ever implemented. From the sidelines, pundits and commentators have tried - mostly in vain - to make sense of the whole circus. Ever since Chairman Bernanke's $600 billion bribe to entice speculators back into the water, gold has been on a wild ride. After breeching the $1,400 mark to set a new nominal record, the Midas Metal has since slid back down below $1,390 per ounce. Single day moves of $20, $30...even $40 have been the norm as markets kick and buck and investors look for a place to avoid the fallout from the Fed's systematic dollar debasement. The question on everyone's lips, therefore: is gold poised to embark on its final "mania" stage? Or is it due for a violent, short-term correction? The question is more than just one of short-term gains in the metals market, important as that may seem. It is also an academic one, and one that underpins the very fabric of the global monetary system. In this weekend's guest essay, Robert Murphy, adjunct scholar at the inimitable Mises Institute, provides some details on fiat currencies, golden anchors and the resurgence of what author Nathan Lewis calls the "once and future money." Please enjoy... Gold: The Market's Global Currency by Robert P. Murphy Nashville, Tennessee World Bank president Robert Zoellick has stirred up a hornet's nest with his recent call for a return to a gold anchor in the global financial system. The usual suspects immediately denounced him, with Keynesian Brad DeLong anointing Zoellick the "Stupidest Man Alive." In the present article I'll explain the resurging interest in the yellow metal. I'll also explain the dangers of Zoellick's proposal, and why fans of the classical gold standard should be wary. The Limitations of the Printing Press In order to make sense of our current situation - and why Zoellick would timidly call for a return to a pseudo-gold standard - we need to first think through the logic of fiat money.Fiat money is not "backed up" by anything; it is intrinsically useless paper (or nowadays, mere electronic bookkeeping entries) that is valuable only because of its anticipated purchasing power. In contrast, a market-based commodity money, such as gold or silver, is a useful good in its own right, serving industrial and consumer purposes. The critical difference between fiat and commodity money is that fiat money can be produced in virtually unlimited quantities at very low cost. In this respect, the person who controls the printing press of a fiat currency is in a much stronger position than the person who owns a gold mine. With just some ink and paper, the printing press can create a million new dollars quite easily, whereas the owner of the gold mine would need to hire workers to operate expensive equipment in order to bring forth new amounts of gold having the same market value. Yet we shouldn't conclude that the owner of a printing press has unlimited power. For one thing, prices would eventually rise in response to large amounts of new money creation. So printing off, say, $1 million in fresh new currency would buy fewer and fewer goods and services with each successive round of inflation. Even more problematic, the people in the community would abandon the currency if the inflation became too excessive. For example, if a brilliant counterfeiter developed a machine to produce perfect $100 bills in his basement, he wouldn't be able to literally buy the whole world. Long before that point - even if the authorities didn't track him down - people would have ditched the dollar and switched to the use of other currencies. Although our scenario sounds farfetched, it's actually very close to the real world, right now. The only difference is that instead of our hypothetical, brilliant counterfeiter in the basement, we have our actual, less-than-brilliant economist in the Federal Reserve. His name, of course, is Ben Bernanke. The Bretton Woods System The original Bretton Woods system - so named because of the location of the meetings that established it in 1944 - governed international monetary arrangements in the postwar era until Richard Nixon's fateful decision to close the gold window in 1971. Under the Bretton Woods agreement, other nations would use US dollars as their "reserves." The Bank of England, Bank of France, etc., would issue their own domestic currencies, but would maintain stockpiles of US dollars with which they could regulate the value of their own currencies. If the British pound sterling began to depreciate against the US dollar, for example, then the Bank of England could enter the foreign-exchange market and use some of its dollar holdings to "buy pounds," thus bringing the value of the pound back within target. In this way, investors across the globe could feel comfortable with their British financial holdings, because the pound was tied to the dollar. Note the tremendously advantageous position that the Bretton Woods system assigned to the United States. As issuer of the world's reserve currency, the United States had a very captive market. If the Bank of England wanted to increase its dollar reserves by another $1 million, then ultimately Great Britain had to sell $1 million worth of goods and services to Americans in order to earn the dollars. The Bretton Woods system effectively expanded the scope for US inflation to the entire world, thus magnifying the benefits to those who controlled the American printing press. Of course, the other members of Bretton Woods understood these details. The US achieved its privileged outcome in the negotiations because of its economic and military might at that point in world history. But in order to restrain the natural temptation for runaway inflation by US officials, the Bretton Woods system linked the dollar itself to gold. Specifically, any central bank could redeem its dollars for gold at the fixed rate of $35 per ounce. The Bretton Woods system has been described as a "gold-exchange standard," in contrast to the classical gold standard. In the original framework - which was smashed, like so many other aspects of Western civilization, in World War I - each nation tied its own currency to gold. Then, the currencies in turn traded at fixed exchange rates against each other, because of their mutual ties to gold. Individual citizens could present the currencies for redemption in gold, keeping a very tight check on inflation. If any central bank began to issue too much currency in relation to its gold reserves, speculators would begin depleting the reserves, causing the central bank to quickly reverse course. Under the diluted Bretton Woods system, individual citizens had no right of redemption. Most currencies were only indirectly linked to gold (via their link to the dollar). And, of course, even this tenuous link was destroyed when Richard Nixon abandoned the dollar's convertibility to gold in 1971. At this point, the entire global financial system was based utterly on fiat money. No longer shackled by the peg to gold, the Federal Reserve began printing money with reckless abandon. The obvious results were an acceleration in US consumer prices, and an explosion in the US trade deficit, trends that noticeably worsen after 1971: Consumer Price Index (Blue Line, Right Scale) and Balance of Payments as a Share of GDP (Red Line, Left Scale) The Reluctant Return to Gold Say what you will about the powerful people running the global monetary system, but they aren't stupid. They can see as well as the rest of us that there is no "exit strategy" for Bernanke's bouts of massive inflation, or "quantitative easing" as they now call it. At some point, the trillion(s) in excess reserves will begin leaking back into the broader monetary aggregates. At that point, Bernanke or a successor will need to choose between saving the dollar or saving major Wall Street institutions. I predict that he will sacrifice the dollar, and it seems many elites around the world have come to the same conclusion. It is in this context that World Bank president Zoellick writes: The G20 should complement [a] growth recovery programme with a plan to build a co-operative monetary system that reflects emerging economic conditions. This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account. The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today. (emphasis added) To repeat, gold is the bane of central bankers; it ties their hands and limits their discretion when conducting monetary policy. However, the game collapses if people lose faith in the fiat currency underpinning the whole system. As the recklessness of Bernanke's moves becomes apparent to more and more people, the central planners around the world will need to throw a bone to the fearful public. A "basket of currencies," each of which is still fiat-paper money, will not suffice. As Zoellick is a member of the Council on Foreign Relations, and a participant in the notorious Bilderberg meetings, some analysts are understandably suspicious of his motives. After all, if powerful people were trying to introduce a regional currency to replace the dollar - in the same way that the euro has supplanted the traditional European currencies - then it would be necessary to first wreck the dollar. In its place, it would be very tempting to offer a new currency with a tie to gold. In this light, what appear to be "inexplicable" and contradictory actions by the Federal Reserve and other powerful figures would make perfect sense. Conclusion Regardless of the machinations of the political insiders, the laws of economics cannot be denied. Central bankers cannot be trusted with the printing press, especially when there is no formal check on their inflationary policies. It is no coincidence that gold is hitting such heights as investors the world over hunker down for what may very well be a collapse of the dollar system. Joel's Note: Robert Murphy is an adjunct scholar of the Mises Institute, where he will be teaching "Anatomy of the Fed" at the Mises Academy this winter. He is the author ofThe Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. --- Introducing the one investment experts have dubbed... BETTER THAN GOLD! One investment should rocket even faster than gold over the next 12-24 months... yielding at least 3-to-1 gains on every dollar invested... GUARANTEED. In fact, I'm so sure of this, I won't charge you a penny to show you how. Click Here Now For Details. ------------------------------------------------------- ALSO THIS WEEK in The Daily Reckoning... Big Oil Bets On Natural Gas Royal Dutch Shell said that by 2012 it expects more than half of its output will be natural gas - not oil. That is as if Starbucks said it expects to sell more tea than coffee. Yet this prediction is not unusual for Big Oil these days. In fact, most of the big boys are making big bets on natural gas. Uranium - Our "Trade of the Decade" Heats Up! At the start of the year, your California editor dubbed uranium the "Trade of the Decade." Uranium may or may not be the Trade of the Decade, but it has been a pretty decent trade of the year. So far in 2010, the uranium price has soared 35% - triple the return of the S&P 500 Index. BioTime Cracks the DNA Cell Command Code I apologize for the headline. As a writer, I know it's too long. It breaks all the rules of style and aesthetics. Some things, however, are more important than aesthetics - such as life-saving fortune-creating science. Frontier Investing I think there may be a window of opportunity left in frontier markets. Let me explain. In last month's report, I noted that we should think of the US as a "huge money-printing machine that produces an unlimited quantity of dollars". Junk Science This week, the scientists began to have doubts. Like the pope wondering about the resurrection, or the Mormons questioning the veracity of the angel Moroni, the head of the World Bank, Robert Zoellick, shocked the learned world. It's time to start discussing a gold-backed currency, he said. Maybe the crown of creation of modern economics - its centrally managed money - was not such a good idea after all. --- Revealed: The Full Power and Promise of Science's Next Decade... --- Breakthroughs that could give your family FIVE generations of HUGE WEALTH! Expert researcher breaks his silence after 2 years with this shocking new presentation. Get all the details on the most lucrative science breakthroughs ever published, right here. ------------------------------------------------------- The Weekly Endnote: Your average man or woman on the street relies on their elected officials for truth, guidance and honesty not because they trust them implicitly, but because often they don't have the time or inclination to double-check their invariably fatuous assertions. The problem is not (only) that people are stupid, in other words, it is that they are busy. The line we mentioned above, that "capitalism" needed to be "saved from itself," was provided by former Australian Prime Minister, Kevin Rudd, surely one of the most unthinking mammals evolution has produced to date. The statement has a nice ring to it, a kind of quaint earnestness that leads to people repeating it at dinner parties and around the BBQ. The only problem is that it is completely, utterly false. But who's got the time to dig any deeper? People, for the most part, are busy building houses, cutting hair and designing "suckier" vacuum cleaners. After the workaday routine, they are lucky if they get half an hour of quality time with the missus (or mister) after the kids go to bed. They go to friends' houses...play cards...chat about next year's vacation. Here in Buenos Aires, trendy twenty-somethings hang out in Plaza Serrano, drinking wine and coveting their neighbors' wives from behind designer sunglasses. Elsewhere, in sterile offices with official-sounding names, bankers pump and dump trillions of dollars, politicians construct mistruths and fabrications and soldiers fight wars in far off lands. And when they return home, at the end of their day and duty, they put the kids to bed and wonder where all the time went. Enjoy your weekend. Cheers, Joel Bowman Managing Editor The Daily Reckoning ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor atjoel@dailyreckoning.com The Daily Reckoning - Special Reports: Gold: The Truth About Gold Fiat Currency: Using the Past to See into the Future Have You Heard of the OTHER Government Backed "Pension Program?"