Fiat currency: Faith in faith

Bill is away until 17 April. So in his absence, we're bringing you some of his most insightful, caustic and witty observations from the last 14 years. This article was first published on 16 June 2006.

Gold investors who had been holding their breath for weeks had it knocked out of them this week. On Tuesday, the price fell $44, enough to put speculators in a tailspin. Even your editor usually a rock of unproven opinions and a fountain of imperturbable prejudices began to wonder.

What if we're wrong? What if sophisticated, modern financial instruments have reduced gold's role in modern finance? Wouldn't gold act exactly as it has that is, as a commodity? It went up with lead and came down with it, too. But what kind of commodity has no industrial use?

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We wondered then why it had bothered to go up in the first place. After a while, we had wandered so deep into the forest of conflicting and ambiguous thoughts, we needed a helicopter rescue.

Daily Reckoning readers might be wondering and getting lost, too. Today's reflection is meant to provide them with some breadcrumbs.

We begin with two questions:

If we have a faith-based monetary system, what do we have faith in?

When this, too, passes, what will take its place?

That second question is the mischievous one. So, we will answer it first: we don't know. But it is the question itself that is most revealing. Were monetary systems permanent and immutable, there would be no need for them. The present financial system could sit there as unchanging as a harbour light a sturdy guide to the prudent and a warning to the reckless.

Instead, monetary regimes come and go, like the lanterns of Cornish pirates, luring ships onto the rocks to be looted.

The financial history of Argentina is instructive as well as entertaining. There, hardly a single generation got through life without washing up either on the rocks of inflation, the shoals of devaluation, or the soft mud of recession.

One system brought inflation rates of 2,000% per year. When that sank, in came a peso as strong as the dollar. And then, when the new peso crashed, a new, new peso, with a new monetary regime behind it.

Just when people had learned how to get around the rocks, the rocks were moved. Along came another regime with another set of standards. Out on the pampas, people finally got used to financial change. They learned not merely from the record of the dead, but from their own living experience: don't put your faith in any financial system; it won't last.

But Americans can't have learned much from their mistakes; they haven't made enough of them. American paper currencies went bad in the Revolutionary War ("not worth a continental," was the expression that recorded the mistake), and again in the War Between the States (when Lincoln spent more than he could honestly steal from the taxpayers).

The Great Depression, with its devaluation of the dollar against gold, might have taught them a thing or two as well. But there is hardly a single person still alive who learned from it directly.

No, in matters of financial calamity, Americans might have been born yesterday. Soft and dewy, they are ready to believe anything even that their financial system might last forever.

That brings us back to our other question: exactly what faith is it that undergirds our faith-based system?

It is faith, surely, in the dollar, is it not? The dollar is the unit in which Americans measure their wealth. If the dollar were called seriously into question, so would the system itself be. Everyone knows that the dollar is man-made, of course. Like all man's creations, they accept that it is not without its flaws and is subject to improvement.

Man's cars get better every year. And although a man may be happily married, still, walking around a dreary college campus or on a sunny beach, he can still imagine how things might be better with a newer model.

In the case of the greenback, it has lost 95% of its value since the Fed was established. It lost 80% of its value while the present financial system has been in effect. That is, since 1971, when the Bretton Woods system, with its limited connection to gold, was abolished by White House decree.

But while everyone knows the dollar gives ground, few believe it is unreliable. It is not the ruination of the dollar that disturbs people; it is ruination at an unforeseen rate.

Like the Argentines, Americans have learned to live with a greasy dollar. What they're not ready for is one that slips away from them too fast. Or even less one that doesn't budge.

Their faith is broad. How deep it is, we won't know until it is tested. For the present, "You gotta believe" is the national anthem. Americans believe that their financial leaders have triumphed over sin and science, too. An Argentine recognises that thegovernment will destroy its own currency in order to win votes and power.

An American readily agrees that the Bank of Argentina would do such a thing, but of the Bank of Ben Bernanke, he can't believe it. His faith stops at the metal detectors.

Yes, theoretically, government and its central bank may be tempted to try to create more liquidity than necessary, but no, they won't give into it.

Why not? Because the markets won't let them, comes the unwavering reply. Ah yes, their faith stretches to cover free market speculators as well as government bureaucrats.

Should the feds create too much 'money', it is believed, investors will dump treasury bonds and force up interest rates, thereby reducing liquidity naturally. But for the lastten years, a huge tide of cash, credit and credit derivatives has flooded the world without a word of complaint from the speculators.

Instead, they got rich and built gaudy houses in Greenwich, Connecticut. They figured out how to snooker the system, shuffling and reshuffling money, slipping an ace up their sleeves when no one was looking. Liquidity money in all its forms was lapping around them, but who was going to complain? House prices rose. Stocks rose. Bonds rose. What's not to like?

And finally, the head of the most successful money shuffler of all time Goldman Sachs has just been invited to Washington to take charge of national finances. Could anything be clearer? The speculators are not watching over the feds; they're watching out for them and for themselves.

Meanwhile, in the popular imagination at least, great strides in the science of central banking have been made since the days of John Law. Asked what exactly those strides are, the modern economist shifts uneasily in his chair and mumbles something about improvements in data available to policy makers.

And this is where we begin to make faces. Our eyes roll toward the heavens.

We think of the improved 'data' itself of job numbers perverted by seasonal adjustments and changing definitions of employment that flatter the policymakers, of inflation figures shrunk by taking out inconvenient prices for food and energy and then hedonically act as a prestidigitator, so that they practically disappear from the stage of GDP calculations that have undergone so much cosmetic surgery that they no longer resemble anything familiar or even human.

And we wonder what kind of jackass would take it seriously, let alone rely on such conniving rubbish to formulate public financial policy.

In the past, the detailed information wouldn't have been of much use to bankers, even if they had had it. Their job was simpler. All they had to do was to make sure they could pay their debts in gold. When they couldn't, they went broke.

If they were central banks, the whole nation went broke. As simple as the job was, many still couldn't do it. Shady countries in sunny places routinely went belly up. Even in America, during the Great Depression, 10,000 banks went bust.

The Bank of the United States of America, run by the former chairman of the Princeton economics department, needs data because its mission has crept far beyond policing the value of the dollar. Expectations have inflated, too. Now, the Fed is expected to control the rate of decline of the dollar a decline of about 2% per year is considered optimal.

And if that weren't hard enough, the Fed is also asked to control the economy itself regulating the availability of credit so as to avoid serious downturns. That is why the Fed lowered interest rates to 1% following the deflation scare of 2001. It had nothing to do with protecting the value of the dollar and everything to do with avoiding a deep recession.

Not only do central-bank scientists have more data at their fingertips, they have more theories, too. Liberalism. Keynesianism. Monetarism. There's one for every purpose under heaven. It doesn't matter that they are contradictory. The banker is merely expected to choose the one that suits the situation and use it like a socket wrench. Crank. Crank. Problem solved.

And so, drawing on twisted data and convenient theories, the banker adjusts rates by quarter points. The prevailing theory in all the Western nations is that centralised planning is ineffective, troublesome, unethical and stupid. There's hardly a serious economist over the age of 18 who will not point to the former Soviet Union and sneer.

"The market," they will tell you with a superior tone, "does a better job of regulating supply, demand and price than bureaucrats." And yet, the operating theory of every central bank is that a group of civil servants, working with government data, can fix the price of the key set of components in the entire economic system: credit.

The economists may have their theories, their insights, their models, we allow, but how do they know that what the world needs is a fed funds rate of 3.75% rather than one of 4.0%? And how do they know whether they should be tamping down on inflation or goosing up a business downturn?

They may have mountains of data, but they are still lost on the slopes. They cannot tell us what the price of oil will be tomorrow or the price of sugar or the price of gold. They take their guesses along with everyone else.

Because the numbers are corrupted, the theories are a hodge-podge of wishful thinking, myth and delusion. And the practice is that both officials and speculators collude to take advantage of the corruption and the delusion. Speak the truth to this kind of power? You might as well save your breath and buy gold.

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