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WhichWayGold Five Minute Summary

Part 1 - The Journey to a Stable Monetary System

Introduction - What is Inflation & Why is it a Risk?

At the time of writing (July 2009), I have some grave concerns that the massive stimulus measures introduced by governments around the world in response to the financial crisis will lead to an unrecoverable and therefore uncontrollable inflation a few years down the line. Anyone holding paper assets such as cash, savings, bonds, gilts, treasuries and anyone relying on pension income or a fixed income stream will see their wealth disappear as the inflation plays out. I am particularly concerned about the outlook for assets denominated in US Dollars and British Pounds.

The majority of people believe inflation to be rising prices but inflation is actually the decrease in the value of money due to the printing of an excess of it. Each new unit which is created reduces the value of the units which preceded it, such that an item purchased after the money printing has occurred requires a higher number of units (as each one is now lower in value) than were required to purchase the same item before the money printing occurred. As a direct result of the money printing, prices appear to rise. Our real salaries have fallen, our savings have fallen and our quality of life has fallen. We need more paper dollars and pounds to buy everyday products than we used to. This story is now entering its final chapter and the final inflation of our currencies will destroy the wealth of those who do not understand how it works.

The Journey To A Stable Monetary System

Early man had simple needs: food, water and shelter.

Indirect Exchange & the Introduction of Gold & Silver as Money

In order for society to progress, man entered into barter transactions, making direct exchanges of goods and services in order to meet his needs. However, the barter system is limited by “indivisibility” and the “lack of coincidence of wants”.

The Benefits of Gold & Silver as Money

For society to take a leap forward mankind required a commodity which is divisible into small units without loss of value, which is durable over long periods of time and is transportable over large distances. Throughout the ages, by trial and error and in competition with all other commodities, gold and silver shone through as the preferred media of exchange and became referred to as “money”.

Gold & Silver Units & the True Money Supply

As a commodity, the unit of account for money is the weight of gold and silver. The supply of money is therefore the total weight of gold and silver existing in society. It makes no difference what the money supply is, since a rise in the money supply reduces the purchasing power of each gold or silver ounce, while a fall in the money supply increases the purchasing power of each ounce. There is therefore no need for the supply of money to be regulated.

The Introduction of Money Substitutes

It is cumbersome to deal with stocks of metal moving between parties in return for a particular good or service. Instead, we could deposit our gold and silver at a bank and receive a receipt of our holding in return – a bank note. These bank notes can then pass between parties during economic transactions, shifting the entitlement to the gold and silver money without the need to move the physical metal. In this way, receipts for money come more and more to function as money substitutes.

Under a gold-backed system, money substitutes do not impact the money supply since they are simply receipts for actually-deposited gold. The notes can only be used as a convenient stand-in for the gold, not as an increment.

The Benefits of Gold & Silver Money on a Global Scale

The above is basically a simple form of a “gold standard”. The money substitutes are backed by gold and are convertible “on demand” back into the money metal. Many countries have previously existed under some form of gold standard for centuries. The limited supply of gold money forces discipline on nations, ensuring that the economy of a particular country does not overheat and that the country’s economic relationship with other countries remains stable.

Price Setting Under A Gold Standard

We have seen that the money supply has no bearing on our wealth and that one money supply will do as well as any other money supply. We have also seen that if the supply of money does change for some reason that the free market will simply adjust prices by changing the purchasing power. So what stops us raising prices to whatever level we wish? Buyers and sellers of any one kind of thing, such as food or medical care, do have some freedom to increase the prices, but every dollar more that a buyer spends for food or medical care is a dollar less that he can spend for something else, and every increased price of one thing must come out of a decreased price of something else. Prices therefore remain generally stable.

Part 2 - Government, Government Spending, Inflation & Instability

Introducing Government, Spending & Inflation

In order to survive, an individual must create value. In contrast, governments do not create value and in order to exist they must seize assets. Such seizure is called taxation and is always unpopular. A big problem arises for a government when it wants to spend more money than it has available. In this case it must impose additional taxes.

From Gold & Silver Money to Worthless Paper Substitutes

A government can tax the public without its knowledge through the process of “Inflation”. The government simply prints more money so that it might spend it. However, each new unit of money which is printed to fund government spending reduces the value of the preceding money units, thereby reducing the wealth of those who have worked hard to save or invest money beforehand.

A Repeating Pattern of Government Inflations

Before a government can successfully embark on an inflationary pathway, it must first seize a monopoly of the minting business, declare what is legal tender, and slice through the notion that gold and silver are money. Weights of gold and silver are replaced by a “national currency” name and the money supply is no longer related to the amount of gold and silver in society. Unfortunately for us, the proliferation of money substitutes and electronic banking in the twentieth century made it easy for governments to unshackle themselves from the discipline of the gold and silver money system.

The Story of the Great American Inflation

Recently, between 1944 and 1971, the 44 major industrial nations agreed to fix their currencies at a certain price against a certain quantity of gold. The agreement was called Bretton Woods. However, following massive expenditure in the 1960's, in 1971 the U.S. suspended the convertibility of dollars into gold and by 1973 the major industrial countries agreed to end Bretton Woods and to let their currencies float freely against one another. There was then no correction mechanism in place to prevent economic excess.

The Exponential Increase of Worthless Paper Substitutes

As the requirement to peg their currencies to gold was lifted, countries began creating un-backed money substitutes at an unprecedented rate. Rather than pay for their purchases in gold, governments issued paper money (e.g. debt instruments such as bonds) as payment. Since there is no limit to the production of paper money, the supply of money has increased at an exponential rate since the early 70’s.

Where Does All the Paper Money Go?

The new money which is created disseminates throughout the economy in two ways: through national product transactions (goods and services) and through capital transactions (investments). The distribution of money demand between the two markets is not fixed and there is no dam between these markets – as money demand moves from one market to the other, prices must go down in the first and up in the second and vice versa.

Capital Markets: A Store of Future Inflationary Potential

Our excess money feeds into the capital markets via savings accounts in banks or through investments. The significance of this is that the capital markets are a holding container for a later, devastating inflation. Despite government’s massive money printing appetite, we have not yet experienced dramatic increases in the cost of the essential items we need to survive, namely food, fuel and water. But if something were to cause the money sloshing around in the capital markets to feed into the national product pool, we would see almighty price rises and a dangerous scramble for life’s essentials.

Part 3 - The Collapse

The Collapse

The U.S. and U.K. governments have now taken us so far down the inflationary path they chose to follow when the gold-backed money system ended, that the plain fact is that any future prosperity or boom will not be possible without more inflation. If the US or UK attempt to stop the money and credit growth the resulting credit squeeze will strangle any signs of recovery, businesses and consumers alike will scream. At every hint of trouble in the economy the easy money policies will resume, the debt and money printing will accelerate and will never stop until the bitter end.But if trust in money is lost through inflation, the existing money which has been employed in capital markets will leave them for the national product market, dramatically inflating prices there.

The Loss of Trust

The economics of disaster commence when the holders of money wealth revolt, getting rid of their money and declining to hold it any longer than necessary to get rid of it. Taking example from the German hyperinflation...“The desertion of the money holders has many of the aspects of a panic, like any desertion in the thick of a struggle. A filling of inflationary reservoirs in the capital markets which may have taken years may be emptied in a day.”

“[Money] velocity started to rise with moderate vigour in the summer of 1921, when Germans began to smell a governmental rat, and that signalled the gradual emergence of the latent price inflation. Velocity took an almost right-angle turn upward in the summer of 1922, and that signalled the beginning of the end. An explosive rise in velocity thus accurately marks the point of obliteration of an inflated currency, but it does not cause itself. People cause velocity, and they only cause hypervelocity after prolonged abuse of their trust. The German mark had been undergoing massive dilution for over two years, and the people only at last realized it when they turned on the velocity.”

The Winners & Losers in Inflation

The biggest losers in the inflation are the savers, the pensioners, those who are reliant on fixed income, those who have cash, bonds, treasuries or gilts. When the paper money that they have carefully accumulated, saved or invested is revealed to be worthless, this class of people is left with the most staggering permanent loss.

When the desertion of paper money becomes widespread the prices of desirable things rise. Government debt will quickly be deserted and the enormous quantities of money which previously occupied that pool will flood out into real, tangible assets such as precious metals, food, fuel, land, etc. Even the money which was previously occupied in buying and selling goods and services, many of them now revealed to be useless, leaves them in favour of real assets. For those in search of protection from the final ravages of inflation and steeply rising prices I recommend gold, silver and platinum.

The Conclusion

Until the early 70’s our currencies were backed by a store of value – gold. In 1971 the U.S. suspended the convertibility of dollars into gold and by 1973 all of the major trading countries had agreed to follow suit, letting their currencies float freely against one another. From that point onwards the world’s major currencies have not been backed by gold, or any other store of value for that matter.

So, nowadays money is just a piece of paper. Its value depends on how many of those pieces of paper are in circulation. Oh dear! The world’s governments and central banks own printing presses, or their electronic equivalents, and for the last 30 years these have been running at full speed, causing the global money supply to increase exponentially.

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Current Federal Reserve Chairman Ben Bernanke.

Money printing has become even more prevalent in response to the global credit crisis. The monetary powers are completely focused on bailing out the financial system and have now taken us so far down the inflationary path that any future prosperity or boom will not be possible without more inflation. Government will print more money in an attempt to “buy the boom”.

The only limit to perpetual money printing is the credibility of the currencies involved and I believe that the credibility of US Dollars and British Pounds is evaporating. The risks of hyperinflation - a complete loss of trust in our currencies and a currency default - grow stronger by the day.

As a result of the coming inflation I see the prices of gold, silver and platinum increasing due to their safe haven status, their ability to store wealth and to hedge against inflation. The precious metals may suffer from market volatility over the short term, but longer-term their destiny has already been set out by the actions of government today.

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