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All That Glitters


Few topics are as off-radar to investors as the topic of fiat vs. gold-standard currencies. We tend to focus on the daily ticks, headlines, charts, and economic releases because, well, that's where the action is. But make no mistake, the current debates about the US$, our current account deficit, the bond market, the Fed's aggressive reflationary efforts, and the persistent unemployment problems the US economy is facing are all inter-related. They are all branches, twigs or leaves of the same tree; and that tree is fiat money.

A full discourse of the costs and benefits of fiat currency is not possible in one article (not, perhaps, even in a series of them, though I would love to give it a try someday). But at least understand that (1) there are, in fact, costs to a monetary system of fiat money and (2) there is also an alternative.

Not convinced of #1 above? In 1971 Nixon abolished the Bretton Woods agreement, which removed the last vestiges of gold-backing for the US$; you could no longer trade in your dollars for actual gold. At the time, total M3 (roughly the total US money supply) was $776 billion. Today it is $8.9 trillion, an 1100% increase. The national debt in the same year was $408 billion. Today it is $6.8 trillion, a 1600% increase. And since that time, the US$ has lost almost 80% of its purchasing power.

Of course, a lot of good things have happened in that time, like rising productivity and increasing standards of living (at least by conventional econometric measures). But there have been real costs to this fiat system, just two of which I mentioned above.

When I and others refer to booms and busts, of the Fed's reflationary tactics, and of the malinvestment that such reflation engenders, it is important to understand that those concepts are only possible because of a fiat currency. It is because the Fed has been given the power to control the money supply by, to use one obvious example, buying or selling US Treasuries, that we have the following cynical (but, sadly, practical) investment quip from George Soros (John Succo first posted this quote on this site in July):

"Economic history is a never-ending series of episodes based on falsehood and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited."

To be sure, fiat vs. gold-standard currency debates are rare these days in any medium. And bringing it up can get you blank, disdainful, or even angry stares at cocktail parties. You do so at your social peril. But understanding the whats, whys, whos and whens of fiat money is absolutely essential for understanding the current, and prospective, economic environment. If there is room on your bookshelf, make space for some literature on the subject.
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