Don’t trust money you can’t hold in your hand

Please remember this warning when it happens. That is, when you go to the ATM to get cash and there is none.

Yes, while we were thinking about what is really going on in today’s strange new money system, a startling thought occurred to us.

Our financial system could take a surprising and catastrophic twist that almost nobody imagines, let alone anticipates. Do you remember when a lethal tsunami hit the beaches of Southeast Asia, killing thousands of people and causing billions’ worth of damage? Well, just before the 40-foot wall of water slammed into the coast a very odd thing happened: the water disappeared.

The tide went out farther than anyone had ever seen before. Local fishermen headed for high ground immediately. They knew what it meant. But the tourists went out onto the beach looking for shells!

The same thing could happen to the money supply. Cash could evaporate suddenly and disastrously – just before we drown in it.

Here’s how and why:

What we use as money today is mostly credit. It is provided to us by the credit industry. We never see it, or touch it, or count it out, or lose it behind seat cushions.

The financial industry makes profit – a lot of it – by offering this new credit money to us; it’s happy to produce as much as we are willing to pay for. After all, it costs the banks almost nothing to create new credit. That’s why we have so much of it.

A money system like this has never before existed. And this one has existed only during a time when credit was undergoing a huge expansion. So our money system has never been thoroughly tested. How will it hold up in a deep or prolonged credit contraction? Can it survive an extended bear market in bonds or equities? What would happen if consumer prices were out of control?

Our current money system began in 1971. It survived inflation at 13% per annum in 1980, but Paul Volcker was already on the job, restricting the supply of new credit and bringing inflation under control. Our system survived the ‘credit crisis’ of ’08-’09. But then, Ben Bernanke increased credit flow dramatically, by bringing interest rates down to near zero and buying trillions’ worth of bonds.

The next crisis could be very different. Key lending rates are already at zero or below (ZIRP (zero interest rate policy) or below-ZIRP). Central banks are now buying more than 100% of new government debt (QE). Overall, debt has reached levels never before seen, and continues to grow far in excess of what the real economy can support.

At some point, a debt correction is inevitable. Debt expansions are always, always followed by debt contractions. There is no other way. Debt cannot increase forever.

When that debt contraction happens, ZIRP and QE will not be enough to reverse it, because they are already running at open throttle. What then?

Anything could set off a credit crisis: when it starts, the value of debt drops sharply and fast. Creditors look to their borrowers, traders look at their counterparties, bankers look at each other.

Suddenly, no one wants to part with a penny for fear he may never see it again. Credit stops.

It’s not just that no one wants to lend, no one wants to borrow either – except for desperate people with no choice, usually those who have no hope of paying their debts.

As in the crisis of ’08-’09, we can expect a quick response from the feds. The Fed will announce unlimited new borrowing facilities. But it won’t matter. Housing will be crashing; who will lend against the value of a house? Stocks will be crashing; who will be able to borrow against his stocks? Art, collectibles, resources – all will be in free-fall; all America’s collateral will be dropping fast.

In the last crisis, every major bank and investment firm on Wall Street would have gone broke had the feds not intervened. Next time, it may not be so easy to save them. The next crisis is likely to be across all asset classes. And with $60trn more in worldwide debt than in ’07 – it is likely to be much harder to stop.

Are you with us so far? Because here is where it gets interesting.

In a ‘normal’ money system – one with, say, gold coins or even pieces of paper – prices fall. But the money is still there. Money becomes more valuable. It doesn’t disappear. It is more valuable, because you can use it to buy more stuff. Naturally, people hold onto it. Money velocity falls, making it appear that the ‘supply’ of money is falling too.

But imagine what happens in a credit money system. The money doesn’t just stop circulating; it vanishes, because the credit behind it disappears. Prices on everything fall. Suddenly, the ‘credits’ are no good. A person who had ‘assets’ (secured by credit) of $10,000 in June, may have zilch by July.

A corporation which put its cash into its own share buybacks one week could find those shares cut in half two weeks later. A person with a $100,000 equity portfolio one day, could find his portfolio has no value at all a few days later

All of this is standard fare for a credit crisis. The new wrinkle – a devastating one – is that people now do what they always do, but are forced into a radically different way. They stop spending, and they hoard cash. But what cash to do you hoard when most transactions are done on credit? Do you hoard a line of credit? Do you put your credit card in your vault?

No. People will hoard the kind of cash they understand, something they can literally put their hands on, something that is actually gaining value rapidly. They’ll want real dollars; real paper money.

These real paper dollars will quickly disappear. People drain cash machines. They drain credit facilities. They ask for cashback when they use their credit cards. They want real money, old fashioned money that they can put in their pockets and their safes at home.

Let us stop here and remind readers that we’re talking about a very short time period; days, maybe weeks, or a couple of months at most. That’s all. It’s the period after the credit crisis has sucked the cash out of the system and before the government’s inflation tsunami has hit.

As Ben Bernanke put it, “a determined central bank can always create positive consumer price inflation”. But it takes time!

During that interval, a panic will set in, with people desperate to put their hands on dollars to pay for food, for fuel, and anything else they need.

Credit may still be available. But it will be useless. No one will want it. ATMs and banks will run out of cash. Credit facilities will be drained dry of real cash. Banks will put up signs, first: “Cash withdrawals limited to $500”. And then: “No cash withdrawals”.

You will have a ‘credit card’ with a $10,000 line of credit. You have $5,000 in your debit account. But all financial institutions are staggering. And in the news you will read that your bank has defaulted and been placed in receivership. What would you rather have? Your $10,000 line of credit? Or a stack of $50 bills?

You will go to buy petrol. You will take out your credit card to pay.

“Cash only”, the sign will read, because the whole machinery of the credit economy will be breaking down. The petrol station, its suppliers and its financiers do not want to get stuck with ‘credit’ from your bankrupt lender.

Whose credit cards are still good? Whose lines of credit are still valuable? Whose bank is ready to fail? Who can pay his mortgage? Who will honour his credit card debt?

No one will know the answers. Quickly, they will stop guessing, and turn to hard, cold cash.

Our advice: keep some real cash on hand. You may need it.