Posted by Michael Donelly

Read this if: You would like to get a basic understanding of why we are in a financial crisis.

Gain: Protect your assets

Cost: The cost of ignoring the crisis is likely to be much worse.

I have a hard time explaining to people why they should buy gold when it’s already up 500% since 1999. “Why should I buy it when it’s so expensive?” my mother asked last year.

It’s so hard to explain because the reason gold is rising is a very abstract concept. Most people don’t know anything about the mechanics of money and delving into the investment websites to learn about it is probably as alluring as being smashed in the face by Hulk Hogan for most.  So here on our little blog where we deal with how to make life easier and better, I will try to cover the basic concepts of how money works and why the system we are in now is dangerous and eventually will blow up in our faces. Here goes…

What is Money?

Since the dawn of civilization money has been a medium of exchange to be traded for goods and services and a store of value (a way to keep one’s wealth to spend later). Historically money would be made of a precious metal like gold, silver, copper or platinum. When money contained a valuable metal the only way to create more money was to dig more out of the ground. People generally could trust the money they owned because it had an intrinsic value in itself. This is known as “honest money”.

When the early kings, emperors or countries got into financial difficulty they had the incentive to cheat to settle their debts or to raise money for war. They would clip precious metal off the coins and mix in something less valuable. This was known as debasement. One of the first recorded debasements was during the Roman Empire. Coins declined in purity over several centuries and the degree of decline in purity was directly related to the strength or weakness of the empire at the time. Debasement allowed the mint to produce more coins. The benefits of these extra coins went to the ruling powers who spent these coins into circulation. The problem with doing this is that more coins in circulation would lead to a reduction in each coin’s spending power and the prices of goods would rise. This has come to be known as inflation.

Inflation was not such a serious problem in itself when it happened gradually through debasement of coinage. A far more serious problem occurred when money lenders discovered they could lend money out many times over. This allowed them to create money from thin air. For example let’s say one money lender had 1,000 gold coins on deposit. He discovered that he could lend these coins out many times to borrowers because some of these borrowers would then deposit them back with him or they would use those coins for business and someone else would come and deposit those coins back with the same money lender for safe keeping and to earn interest. Essentially he would have loans and deposits on the books for say, 10,000 coins but only ever have 1,000 real coins in the vault. The other 9000 coins he had on deposit were merely an accounting entry and did not really exist. He could even write paper promissory notes bearing his name which were traded among merchants, meaning no money never left the vault at all. This was very good for him because he could charge interest on 10,000 coins to borrowers instead of 1,000.

I know, this is abstract and hard to understand if it’s the first time you have come across it. Rather than understanding the mechanism exactly, the important thing is to know it happens. When you realize this occurred on a large scale you can see that it put massive amounts of money into circulation over time. In the same way Romans had debased money, this was an inflationary process.

How Bank Collapses Happen

Most of the time this would not be a big problem, but occasionally in times of hardship rumours would begin that money lenders were unable to pay their depositors. All depositors would come to withdraw their money at once and of course the money lender would only have a tiny fraction of what was required in the vault. Each depositor would take a 90% loss on his deposits. This came to be called a “bank run”. When bank runs happened simultaneously on a large scale they decimated the local economy. Suddenly the amount of money in circulation decreased brutally and the result was deflation (falling prices). In the great depression of the 1930s for example, a deflation occurred because debts built up in the roaring 20s were payable in gold. There was not enough gold to pay all the debt and the bank runs began. Throughout the 30s 9000 banks failed in the Unites States causing a massive contraction of money in circulation.

Banks Will not Collapse this Time

However what happened in the 1930s will not happen today. There is one key difference. In the 1930s paper money was convertible into gold by most of the big countries’ governments, including the US. This meant  that anyone could go with a dollar bill to a bank window and exchange it for a fixed quantity of gold. Today this no longer the case. Initially after the 1930s depression  governments stopped private individuals from doing this and made it possible only for governments to exchange their currencies for dollars and then those dollars for gold. Paper currencies were still theoretically convertible into gold, even if not for the common man. But in 1971 because the US had created too many paper dollars, the US completely suspended convertibility. Since that day the world’s currencies have been backed by exactly nothing.

This is where we find ourselves today. Nowadays if a government wishes to pay bills, all it has to do is print more money. Ordinarily governments would try to restrain themselves from creating too much money. When they didn’t restrain themselves it ended in what is known as hyperinflation, completely destroying the value of the currency in a very short time. This occurred in recent years in Eastern Europe after the collapse of communism, in Argentina and in Zimbabwe.

It’s the Governments that will Collapse

We are nearing a time now when governments will have to create massive amounts of money and will not have a choice in the matter. Why? Let’s look at what happened to money since the 1980s.

Remember the example of the money lenders. In a system where gold coins were money banks could theoretically create 10 times as much money as really existed. Today the situation is far worse. Not only can banks do this but the money they keep in the vault is just paper issued by the government, unbacked by anything real. If any government had to convert all its currency back to gold today at the market price of gold they would find themselves woefully unable.

So now we have the banks creating money out of thin air, on top of the governments also doing the same. Unfortunately that is not the end of the story. Banks have also realized they can create wealth for themselves in other ways. They have invented more paper promises called derivatives. These derivatives are basically paper promises to take money from one person and pay it to another. The derivatives market is huge and if there were even a small number of defaults by people owing money to the banks it would wipe out those banks completely. In fact this already happened on a small scale in 2008 and 2009 when the initial crisis hit. When banks got into trouble, governments borrowed and also printed money and gave it to those banks so they would not default on their obligations. If government money was backed by gold this would have been impossible and the economy might have collapsed at this time.

Protect Yourself

Maybe now you can get a feeling for why the price of gold is rising? People still believe after 5000 years of gold being money that ultimately gold is protection against their paper money becoming worthless. The more governments are forced to print to stave off financial collapse, the less paper money will be worth, and the higher the price of gold will go. By borrowing to save the banks in 2008 governments have made themselves insolvent. They are reaching a point where the interest on their debts is impossible to pay from tax revenues, and the only way to pay those debts will be to print more money. When that happens we can look forward to hyperinflation the world over. Prices will be so high your savings will buy precisely nothing.

When might this happen? The day is not far off. Currently governments are able to pay their interest bills because interest rates in many countries are being kept artificially low. These rates will be forced to rise soon as the markets demand more return for their risk of holding paper money. When rates rise heavily indebted (read:most) governments’ finances will become a shambles and those governments will have to default or print more money. History suggests because politicians prefer to delay the day of reckoning as long as possible they will opt to print rather than default.

You can protect yourself to a degree by owning real assets. If a hyperinflation comes about, these assets will still be yours when it is over. Most of all, you can buy gold because when the economy starts again after the big “reset” gold is most likely to become money once more.

Further reading:

Is the US Dollar in Danger of an imminent collapse?

Protect your wealth

FOFOA

Jim Minclair’s Mineset

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