Economic Recovery, Confidence, and Fiat Money

We've been tracking the dollar, commodity, and equity movements here at Dredd and showing their interrelationship. What's important to take away from this is simply that the increase in the value of the global equity markets has little to nothing to do with "green shoots" and everything to do with the destruction of the currency.

If you watch any Bubblevision--those financial stations where the reason for market moves changes every 10 minutes--for your information on the health of the economy, let's just say you're going to be sadly disappointed that we completely disagree with the consensus view. There is no economic recovery underway. None. Zero. All effects you see are illusory, as will be revealed in our upcoming latest installment of the "Where?" series.

As we've mentioned before, the root of this problem is debt, pure and simple. There's too much government debt, corporate debt, and personal debt all around the world. In the case of the United States, 70% of the GDP is based on consumption. Guess what? That's much too high a percentage of the economy to be based on consuming things. Given that consumers are tapped out, how can there be an economic recovery without fundamentally restructuring the economy and monetary system? The two are intimately related. Somehow, most of the industrialized economies of the world, notably western Europe and the US, decided that they could develop ideas locally, outsource all of the work, and then buy back all of the things that were produced elsewhere. We have some news for you that you won't see on Bubblevision--that is not sustainable if the balance sheet of the country is negatively effected over time. A country as a whole cannot consume more than it produces, especially on borrowed money (credit). Any business that ran that way would close its doors in short order.

So, how did we all get into this mess and what's going to happen? To summarize the situation in less than a 1000 page report, two ideas have combined to produce the effects we're seeing today. The biggest one is fiat money. That's what we're going to focus on today.

Debt-Based Money
We've commented before on the role of money as a store of value, on how money is created, and similar topics. Given that this is at the root of the global problem, we need to really dig into is some more.

You must realize that the entire monetary world we live in is less than 36 years old. We live in a giant experiment where nations trade with one another based only on a promise. Never before in human history has this been done, and we believe that this experiment will end in the near future.

Prior to 1973, the world had at least some form of gold standard (we will produce an essay on the history of money in the modern era soon). Why gold? We've discussed this before in several articles, but in short, gold just seems to "naturally emerge." In reality we could have a monetary standard based on anything "real." The value with having a commodity based international monetary system is the concept of "no counterparty risk."

Free Beer Tomorrow
At issue is the question of "what is the value of the currency based upon?" Let's look at an example. If I raised chickens, you raised wheat, and there were no money, would you take my promise to pay you in the future continually in exchange for your wheat? You may loan me credit for a period of time since we're so close, but after a while, you need chickens or eggs, or something of value from me. If all I ever give you is a promise that I'll give you something, it is not long before you stop giving me credit. It's like the "free beer tomorrow" sign that sits as a joke in the local bar.

This is a microcosm of what occurs with fiat money. Fiat money is based on debt issuance by the Treasury. Every dollar that exists (or any currency that exists for that matter) is borrowed into existence. So anyone that accepts that currency is accepting a future promise to repay debt. But of course, almost all currency is debt. So how can you repay the debt with money that is itself debt? Obviously you can't. That's the inherent flaw in the system.

At some point, the debt burden, which includes all issued money, becomes impossible to service. It's very counter intuitive, we know, but that's simply how it works.

Under a gold standard (or any commodity-based standard), this is not the case. Instead of countries paying one another with a future promise to pay one another (see how quickly the house of cards starts looking ridiculous?), the payment must be made with something based on tangible goods--a commodity like gold, oil, or food.

This may seem rather pedantic. Does it really matter? Absolutely. Let's look at a relevant example.

The emerging markets, notably China, have been working on building up their economic progress for decades by slowly getting out of the communist, centrally planned economy model (which they know from experience is doomed to failure) and moving toward a more open, market-based economy (note that the trend in industrialized nations, while still free-er than China today, has been moving the opposite direction for decades). As a nation, China's citizens have been investing their labor to produce real things and have been selling those things to industrialized nations in exchange for debt-based money. In reality, this has been a good deal for industrialized nations. They have issued promises to pay (debt-based money) in exchange for tangible goods (regardless of what you may personally think about Chinese quality). It's a good deal. It's akin to me promising to pay you for wheat without ever actually giving you anything in return other than a newly minted IOU.

Note here that the fundamental ability for this system to function depends on confidence. Fiat money systems are inherently confidence games. If you believe that my promise to pay is as good as delivering chicken and eggs, then you will continue to give me wheat for nothing. It's a great deal for me. In order to keep it going, I have to keep promising. At some point, if your confidence starts to waver and you refuse to accept my promise, then I have a problem. Until then, you have a problem but you don't know it as long as I have your confidence.

So, what causes confidence to fail? That's the situation we're facing. The answer is surprisingly simple and obvious. Promising to pay too much too often will eventually cause the game to end. In a fiat currency system, this is simply issuing more and more money (which is more debt) at increasing frequency. And of course, since it is debt, it must be repaid. To repay it, there must be more debt issued. So the cycle is self destructive over time. You cannot pay off debt without more money, but the money itself is debt. At the same time, if you are trying to buy real goods and you have little to offer in exchange for the real goods except debt-based, fiat money, then you must continually create more debt, which is more money, which is inflationary, which then devalues the money, which then required more debt to create more money, which....

You get the point. It cannot be sustained forever. It is a negative feedback loop, a downward spiral.

Again, unlike the fiat, debt based system, a commodity-based currency is not a future promise. Either the commodity exists, or it does not. It's that simple.

This is the real value of something like gold to you in these times, dear reader. Gold is no one else's liability. It has no counterparty risk. No one has to promise it. Either you have it or you do not (which begs the question about why anyone would purchase paper-based gold, like the GLD ETF, since it defeats the purpose in that you must trust a promise that the gold is really there.) No central bank or government can issue more gold than exists. They cannot create it in a lab (like diamonds). It is in finite quantity.

What are Asset Markets Saying?
As we've been discussing in our (almost) nightly technical market commentaries, we see that everything is trading against the USDX. Markets, like the stock market, are rising because the currency is weakening against other currencies. The markets are not forecasting an end to the "recession" (which in our opinion is the beginning of a depression), they are forecasting problems with the money. After all, this "recession" is based on debt levels, which are intimately tied to the currency. This recession is a monetary problem.

So how are the genius central bankers working to solve it? Well, they're creating more debt and money. "Banks aren't lending to consumers, Dredd," you say. True. Consumers are broke and have few future prospects because they have not jobs related to anything except consumer spending (more negative feedback loop). BUT, the total level of debt is still rising. After all, when the consumer can no longer stand more debt, the governments of the world take on the debt for them through "stimulus" programs. (The debt is not declining, it is simply shifting from individuals and companies to the public/government sector.) The problem is that there no real activity going on to structurally fix the economy--to make nations that consume too much produce more. When the "stimulus" runs out, the economy will crash. If the stimulus is pushed too far, then the creditors will refuse to take debt-based promises any longer and the currency will crash.

The only way to fix this problem is to produce more than is consumed over a substantial enough period of time. Given the debt loads that have been created over the last 36 years, there is no way to pay back that debt (especially since it is growing at a faster and faster pace, simply so that it can pay back previously issued debt). Some form of default is coming, either directly or through massive inflation (the hidden tax that robs money of its store of value property). The monetary system is failing. That is what we must prepare against. That is what we are watching closely. Fortunes will be made and lost soon, and the world will emerge a very different place in the next few years.

The Race to the Bottom
It would be remiss to end here without differentiating between the impact of the value of the USDX and inflation. The USDX is not synonymous with inflation, though they are related. We often discuss the effect of inflation being to raise prices. This is true, but inflation is a difficult thing to really measure, and it may be that a fall in the USDX is perceived as inflation when it is not. This is a key point of our next "Where?"article.

The USDX is a feature of the floating exchange system introduced in 1973 after the US officially left the gold standard in 1971. In this system, the value of a currency can really only be measured in terms of another currency (a currency pair). The USDX is an index of the US dollar weighed against the US' key trading partners. When the USDX goes down, it is going down against a defined "basket of currencies." For most goods produced in the US, the USDX has no immediate impact. For good purchased purchased from the key trading partners, the impact is that the price rises.

The US consumer has been the engine of the world for decades. Foreign countries like Japan, Taiwan, China, and much of Europe have prospered because they focused on creating goods to sell to American consumers (essentially transferring American wealth abroad). So many of these economies are entirely based on selling things to Americans, who are now broke (why they're really broke is a yet another essay).

The result may be a currency war--a race to the bottom. These countries devalue their currency through inflation (creating more money) so that their goods are cheaper for American consumers. Every country will do this, to some extent, as long as they are dependent on more foreign consumers than local consumers, and they will devalue their currency against their national competitors. In this case, the USDX can fluctuate, and prices may rise or fall for foreign goods. But do not be confused thinking that the USDX equals inflation or deflation. It is only a measure of currency flows and only affects prices of goods that are not produced locally. Inflation can and will affect prices regardless of the move in the USDX. As such, the USDX is simply a way of showing the rate at which the US is destroying its currency relative to its trading partners.

We will dig into this topic in more detail next week. We just felt it important to ensure that there is a differentiation in your understanding between inflation and the USDX. A down moving USDX is a sign of more confidence abroad, and a rising USDX is more confidence in the US. World asset markets are being bid up based on confidence in the dollar, and nothing more. It is not a sign of economic recovery. It is a sign of confidence in the largest fiat-based player in the game.