Archive for the ‘Economy’ category

Three Things You Must Consider To Protect Yourself From Inflation

October 19th, 2009

I know this is a hot topic because I’ve gotten several emails and a few Twitter messages about ways to guard against the continually eroding dollar.  The thought of ending up with paper money worth no more than the paper that it’s printed on is a bit scary to say the least.

As you know after reading my article on inflation your best friend in an inflationary environment is something that is NOT linked directly to the currency in question, the US Dollar in this case.  Precious metals, etc certainly come into play here, but there are other less common things you can keep around to help out.  Obviously you’ll need to have food storage and water taken care of to be able to truly protect yourself.  But aside from that, what can you do?

The Obvious:  Buy Gold!

1_oz_goldI’m guessing that the first thing that comes to mind when you think about protecting yourself from inflation or protecting yourself from the dollar collapsing is gold.  Buy gold!  It’s got intrinsic value, and your primer on currency said that’s one of the foundations of real value, Rudy!

Sure, that’s true.  And gold will always be worth something.  Right now gold is trading at about $1,052 per ounce.  Last year at this time gold was trading at just shy of $800 per ounce.  Go back five years and it was just over $400 per ounce.  Talk about appreciation!

There’s only one problem.  Gold is TOO valuable.  A one ounce bar, currently worth $1,052 as I write this, is pretty tiny.  It measures just shy of two inches long by one inch wide and is about 0.08 inches thick.  That’s pretty small.  And pretty darn valuable.

Do you really think that will be valuable for any sort of barter or trade if the dollar becomes worthless?  You can opt to use gold as a storage vehicle for larger amounts of money as long as you augment it with less ‘value dense’ commodities.  If you only have gold, you’re asking for trouble.

Rudy’s Warning: Unless you’re using it as a pure hedge against a devaluation of the dollar, make sure you take physical possession of the gold you buy.  If you buy virtual gold somewhere chances are you’ll never be able to get at it when you need it.  The same goes for silver and other precious metals as well.

The Next Best Thing:  Silver!

junk-silver-bagSilver is definitely less value dense than gold.  Silver is trading at about $17.42 per ounce right now.  This makes it a far better commodity to buy for every day commercial use than gold.  I would recommend that you skip the silver bars and ingots and buy bags of ‘junk silver’.  Junk silver is a term for coins that are worth more for the silver they contain than for their face value.  You can buy junk silver from coin shops, pawn shops, and dedicated retailers.

When buying junk silver you are looking for pre-1965 minted US coins (not pennies!) which contain 90 percent silver.  Coins minted after 1965 contain less, and I’ll talk about that in a minute.  If you’re buying 90% coins an easy rule of thumb is that any combination of coins that comes to $1.40 face value is 1 ounce (technically one troy ounce) worth of silver.  So right now, $1.40 face value of pre-1965 coins is worth $17.42.

The easiest way to buy junk silver is by the ‘$1000 Bag’ which is a bag containing $1,000 worth of pre ‘65 coins by face value.  This bag contains 715 oz of silver and will be priced appropriately, and usually with a surcharge of sorts.  So you don’t have to count the actual face value of the coins, if the bag weighs at least 52 pounds, you’re getting your moneys worth.

You can also buy 40% silver, which is basically silver half dollars minted between 1965 and 1970.  These contain 40% silver.  I would personally avoid them, but if you feel inclined to buy some, go for it!  Note that you can also find these coins in circulation still, so if you ever run across fifty cent pieces, look at the mint date!  You never know when you’ll get lucky!

The Poor Man’s Hedge:  The US Nickel

NickelsThis is something that is less commonly known about but has been advocated by a number of folks, including Jim Rawles at SurvivalBlog.  It revolves around the concept that the Nickel contains 75% copper and 25% nickel and is therefore still worth something.  At the moment the value of the metals in that coin is about $0.046.  It’s not hard to figure out that if the dollar continues it’s slide and/or metals continue to appreciate the lowly nickel will soon become worth more than it’s face value, just like the pre ‘65 silver coinage.

This is more of a pure hedge than something you would plan to use in daily commerce.  Most people don’t know what to do with copper or nickel and wouldn’t know how to melt down the nickels into base metals anyhow.  That said it is likely that they will become valuable just like today’s junk silver is valuable and are thus a good long term hedge against inflation.

Rudy’s Tip: Coin debasing is what happens when the Fed changes the metallic composition in a coin to one that costs less.  Typically the core metal is replaced with zinc flashed with the original core metal.  This happened in 1983 with pennies which went from 95% copper to 97.5% zinc flashed with copper and are now only worth a fraction of face value.  History shows that non-debased coins gain investment value once the melt value exceeds about three times the face value.

As a side benefit, look at what happens in hyper inflation.  If you read my article about hyperinflation in Zimbabwe you will recall that over the course of the inflationary event thus far they have dropped a total of 25 zeros.  Do you think they reissued coins during that time?  Not on your life.  So under similar circumstances if the US Dollar is revalued by dropping digits your nickel would be worth the exact same face value.  For example if the Fed dropped three digits, that Nickel would now be worth $50 pre-collapse dollars.  Not bad.

Where do I get this stuff?

Well, nickels are easy.  Go to the bank and buy rolls of them.  Read Rawles’ post for some more ideas but honestly I have just gone down to the bank and bought them by the roll.  I usually buy about $40 worth at a time.

Gold and Silver are a bit harder.  You can buy locally for sure, or there are online retailers.  For junk silver you can also find E-Bay to be a good source, though I like the guys at GovMint since they have smaller bags available and knock off $25 if you buy more than $150.  Google around for good sources around your area.  This stuff is heavy so it can make sense to buy locally instead of paying for insured shipping costs.  A drive is often worth considering if it’s not too far!

Wrapping Up

I personally stay away from gold.  Silver and the nickel make sense to me.  Think long and hard about what you need and make your decisions accordingly.  One last tip:  If you have money in retirement funds like most of us do, look at the option of diversifying out of the standard mutual fund choices and buying Silver ETF (Exchange Traded Funds) or similar investment vehicles.  It’s hard to get cash out of your retirement fund, but this can help you against a stock market disaster!

One final request … if you have any tips or thoughts on what I’ve written, please share them with the group in the comments below!

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Economy: Anatomy of an Economic Collapse – Zimbabwe

October 15th, 2009

zimbabwe_beer_costI wrote last week about the historical economic collapse of the Weimar Republic due to hyperinflation.  Today I want to write about another collapse that is more recent but also very different in root cause.  The core of the collapse remains hyperinflation, but in the case if Zimbabwe the causes of hyperinflation are drastically different.

A Brief History of Zimbabwe

Prior to 1980 Zimbabwe was knows as Rhodesia and was technically a colony of the United Kingdom.  In 1980 Rhodesia declared independence and called itself Zimbabwe.  The United Kingdom agreed with them and there was all sorts of pomp and circumstance around the event.  A man named Robert Mugabe was the Prime Minister after independence was declared and in 1987 became the first President of Zimbabwe.

Rudy’s Note: As you can probably gather from his long time in office, Mugabe hasn’t really been the most fair towards his competition.  In fact until 2008 elections were rigged even if anyone actually ran against him.  In 2008 Mugabe lost the election, but forced a runoff and used violence to intimidate his opponent into withdrawing from the elections.  What a great guy!

In an attempt to quell public and international outrage Mugabe agreed to put the other guy into the old Prime Minister position as a form of power sharing.  Strangely enough within months of Tsvangirai being sworn in, him and his wife were in a “car accident” that killed her and significantly injured him.  Coincidence?

At the time of independence Zimbabwe had a thriving agricultural economy augmented by significant mineral and gemstone mining operations.  While there were economic sanctions on exports prior to independence, once those were raised there was a significant economic boost exceeding 20% for several years.  By the mid 1980s the economy flattened out and overall for the decade of the 1980s Zimbabwe’s GDP grew by a little over 4%.

Ethnic  and Political Conflict Prevails…

zimbabwe1Throughout the 1980s ethnic conflicts between whites and blacks escalated.  The constitution provided that 80% of the parliament seats would be held by blacks and the balance could be held by whites and other ethnic minorities.  In 1986 an amendment was made for that 20% to make them nominated positions instead of elected positions.

During the ’80s a form of martial law ruled, with ethnic militias and armies continuing to escalate into what eventually became a civil war.  As Zimbabwe continued to descend into single party rule health declined, with up to 25% of the population being infected by HIV.

After economic conditions triggered a series of strikes and protests by workers, students, and minorities the government continued to crack down and exert even more control.  In 1997 Mugabe began trying to redirect the anger to the white farmers which accounted for less than 1% of the population but owned 70% of the farm land in Zimbabwe.  Mugabe decided to begin forcibly redistributing that land to blacks, exiling or imprisoning the white farmers that owned the farms.

This promptly began a massive food shortage that continues today.  Not a surprising result when you take land away from those that made Zimbabwe the bread basket of Africa and handed it over to people who had no idea what to do with it.  Annual wheat production in 1990 was over 300,000 tons but it has dropped to less than 50,000 tons in 2007.  That’s production, not exports.

Rudy’s Note: Jesse Jackson commented on the forced eviction of white farmers in 2006, saying “Land redistribution has long been a noble goal to achieve but it has to be done in a way that minimizes trauma.” Don’t think this couldn’t happen here.  Land, possessions,  or money, there’s plenty of folks in this country that believe in the redistribution of wealth.

Rampant inflation begins

zimbabwegdpThroughout the 1990s inflation fluctuated between 15% and 48% according to official government numbers.  The government continued to strong arm the economy by implementing price and wage controls, running deficit spending, and actively discouraging (violence anyone?) the creation of new businesses.  In the early 1990’s the Zimbabwean Dollar (ZWD) was devalued by 40% followed by the government dropping price and wage controls in an attempt to reign in inflation and increase production.  Despite this rampant deficit spending continued which undermined any gains made by relaxing the stranglehold on the economy.   In 1999 the GDP growth went negative and it’s been there ever since.

Enter hyperinflation

ZWDvUSDchartHyperinflation began in 2001 with the rate of inflation skyrocketing to 112%, capping out at over 600% in 2004.  There was a brief respite in 2004 and then inflation headed for the moon.  In 2006 the central bank of Zimbabwe kicked the printing presses into overtime and printed 21 TRILLION ZWD to pay off foreign debt, followed by another 60 TRILLION ZWD a few months later to finance a wage increase of 300% for government employees.  Conveniently none of this was budgeted.

In order to get out from under this the government decided that the current version of the ZWD was abolished and a new ZWD was issued.  A minor side note on this new currency was that in the process they somehow lost three zeroes.  In other words, the old 1,000 ZWD note was a 1 ZWD note with the new currency.  How convenient!

Proving that Mugabe doesn’t believe in Supply and Demand, in 2007 the government passed a law banning inflation.  Raising prices was now illegal and merchants who raised prices anyhow were arrested and imprisoned.  It didn’t help and inflation went from 1,281% at the beginning of 2007 to 66,212% at the end.  Wages were officially frozen and a ZWD $200,000 note was in common circulation.  Due to the price controls merchants simply stopped selling and workers stopped working.

In 2008 things got really interesting.  Since so much happened that year I’ll bullet point it.  It’s easier to read that way!

  • In January inflation hit 26,470% and ZWD $10,000,000 notes were in common circulation.  They were worth about USD $4.
  • In April, a ZWD $50,000,000 note was issued, worth about $1.20 USD
  • In May inflation hit somewhere between 165,000% and 400,000%.  New bank notes were issued worth ZWD $100,000,000 and ZWD $250,000,000.  Ten days later the central bank issued a ZQD $500,000,000 note worth about $2 USD.
  • In July the official inflation rate was 355,000% though independent estimates were 8,500,000%.  On July 4 at 5pm a bottle of beer cost ZWD $100,000,000,000.  An hour later that bottle sold for ZWD $150,000,000,000.
  • On July 15th the government admitted that they were running out of paper to print money and Germany was reluctant to provide more.  The official inflation rate was now 2,200,000%.  The central bank issued a ZWD $100,000,000,000 note.
  • On July 30th the government conveniently slashed 10 zeroes off of everything, so ZWD $10,000,000,000 became ZWD $1.  All old currency was now worthless.
  • In November a study was released saying that annualized inflation in Zimbabwe was 89.7 sextillion percent.  I didn’t know what that number looked like so I typed it out.  That’s 89,700,000,000,000,000,000,000%.  Prices increased 6,400% between November 7th and 14th.
  • In the first part of December a new ZWD $100,000,000 note was issued.  A few days later the bank was forced to issue a ZWD $200,000,000 note.  Daily cash withdrawals from banks were capped at ZWD $500,000, or about $0.25 USD.

Things continued to slide in 2009 and at this point much of the black market had moved to using foreign currency instead of the ZWD.  In early 2009 the government acknowledged this and licensed a number of retailers to officially sell goods using foreign currencies.  At this point most people refuse to accept the ZWD.  Economic production is abysmal, with unemployment rates over 95%.
On January 12, 2009 a ZWD $50,000,000,000 note was issued.  Four days later the bank announced plans to issue 10, 20, 50, and 100 trillion ZWD notes.  This was notably a gap in the series of banknote values as there was nothing between the $50 billion and the $10 trillion notes.  In February 2009 the currency was devalued yet again.  This time 12 zeroes were chopped off.

Rudy’s Note: Over the course of the economic collapse the ZWD was revalued by 25 decimal places.  If this had not happened then $1 ZWD would now be the equivalent of ZWD $10,000,000,000,000,000,000,000,000.  At some point the central banks had to place expiration dates on currency notes to keep up.

Zimbabwe_Hyperinflation_2008_notes

Wrapping Up

Zimbabwe is a fascinating case study, and it’s not even done yet.  Since it happened relatively recently we have a tremendous amount of data to study and learn from.  It’s critical to recognize that we MUST learn from this sort of thing to prevent it from happening to us.  The problem is that most people don’t learn from history.  Are we doomed to repeat it?  Let me know in the comments section what you think.

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Economy: Inflation? No Problem!

October 14th, 2009

20419cs (320x289)Today we’ll talk about inflation!  I’m hoping you’ve read my article on deflation and depression and my primer on currency.  If you haven’t read those two posts, go read them and then come back and continue here!

In the deflation article we established that deflation is an overall decline in price, or increase in the value of a given currency unit.  In other words, your dollar goes farther.  We also established that inflation is the opposite of that.  Pretty simple, right?  Your dollar buys less and less the higher inflation goes.

We generally measure inflationary rates according to one or more price indexes.  The one everyone is familiar with is the Consumer Price Index, also called the Cost of Living Index.  Other indices are useful as well when measuring inflation in narrow parts of the economy but we’ll use the CPI for the purpose of this article.  The annual inflation rate is simply the annualized percentage change in the CPI as measured by the federal government.

Inflation is bad, isn’t it?

CPI_ChartNot inherently.  Just like deflation, inflation is not good or bad in and of itself.  In fact most economists believe that low steady rates of inflation are a good thing for an economy.  The key is that the inflation rate should stay below the growth rate of the economy at large, or the Gross Domestic Product as we call it here in the United States.  Mild inflation is also key to getting out of a depression or recession.  Mild being the key word there.

On the flip side, inflation can do some bad things.  If inflation begins to rise too high there is a natural response by consumers to spend their money on tangible durable goods before that money is devalued too much.  If you recall in the deflation article we talked about supply and demand and how it drives prices.  If consumers begin buying durable goods, prices go up as demand goes up and that has a circular effect I’m sure you can all see.

Another negative side effect of inflation is something called Cost Push Inflation.  It’s basically the concept that as consumer prices rise, employees demand more and more cost of living increases to keep up.  This is particularly negative with collective bargaining agreements like union contracts and the like which are tied to the CPI.  It can trigger a wage spiral which has the further effect of increasing the inflation rate as businesses raise prices to compensate for higher employment expense, leading to higher wages, ad inifintum.

What happens to debt in an inflationary period?

That depends on the type of debt.  A fixed interest loan, such as a standard mortgage or a contractual loan will become cheaper to pay off.  A variable interest loan will stay about the same in compensated value, but there is a real danger to variable interest rates.  The interest rate will ALWAYS rise faster and farther than your wages will.  Always.

Rudy’s Tip: Inflation adjusted interest rates on fixed interest loans are called ‘real’ rates.  It’s defined as the nominal rate minus the inflationary rate.  So if your fixed interest rate is 8% and inflation is 3% your effective rate is 5%.  If inflation jumps to 8% then you’re essentially paying no interest.  Beyond that and the bank is essentially paying you for the loan.  Funky!

What causes inflation?

640px-Federal_Funds_Rate_(effective).svgWell, if you’re an economist this is where you start talking about the Quantity Theory of Money, the Velocity of Money, Currency Debasement, and other interesting things.  Since we’re in a fiat money economy we’ll limit our discussion to that.  There are really two things that matter in the long run.  The money supply and economic output.  If the supply of money increases too quickly compared to the economy at large that inevitably leads to price inflation based on the law of supply and demand.

Interest rates also play a part here as higher interest rates lead to lower inflation rates and vice versa.  This is why you see a reduction of the federal funds rate in an attempt to kick start the economy.  The theory here is that if money is cheaper to borrow more people will take advantage of that leading to more economic growth and thus higher inflationary pressure.

Great Ceasar’s Ghost!

MarcusAureliusDenarius (310x310)A random final bit of information here.  I talked about currency debasement in the last section.  Debasement in its purest form is when you take a commodity currency (like a gold coin) and melt it down, then recasting the coin with a lower commodity content.  Most historians believe that debasement was one of the leading causes of the fall of the Roman Empire.  The Roman silver  denarius was 95 percent silver when introduced.  Over a one hundred year period it was debased so far that it only contained 0.5% silver.  Yowza.

Couldn’t happen here, right, since we’re in a fiat system?  Nope.  Debasement basically takes a unit of currency and reduces it’s value.  What do you think the Fed printing presses running overtime does to our currency values?

Wrapping Up

That’s it for inflation!  Conceptually pretty simple, especially after reading the deflation article I wrote.  Next we talk about Inflation Gone Wild.  Also known as Hyperinflation or Something That Keeps Rudy Up At Night.  Stay tuned!

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Economy: Deflation and Depression

October 12th, 2009

panic button (320x309)If you haven’t read my introduction to currencies you should go read that now.  Really, I’ll wait.  Now that you’re done, let’s talk about deflation.  Most people hear the word deflation and panic because it sounds really darn scary.

Actually, deflation is neither good nor bad inherantly.  The causes of deflation are the REAL problem.  But I said I’d talk more about what deflation and inflation are.  I decided to write two separate posts on them, starting with deflation as I believe that we are on our way into a deflationary cycle in the United States.

Supply and Demand – A Universal Truth?

I’m going to go out on a limb and guess that most of you understand the basics of supply and demand.  If supply is constant, increased demand will increase prices.  Decreased demand will decrease prices.  If demand is constant, increased supply will decrease prices.  Decreased supply will increase prices.  Pretty straight forward!

Rudy’s Note: Yes, that’s simplified.  No, supply or demand will generally not stay constant.  The relationship is dynamic.  Nonetheless, using this simplified example helps understand it!

Everyone understands that supply and demand works on goods and services we buy all the time.  We see it in our daily lives on a regular basis.  What many people don’t understand is that money is subject to supply and demand as well.  I dabble in currency (Foreign Exchange or Forex) trading and grasping supply and demand as pertains to money is a key factor in successful forex trading.  After just a short time you can look at a chart and see the powers of supply and demand at work on money just like it works on anything else.

This is important because the prices you see in the store are not only related to supply and demand for that individual item or service but also to supply and demand for money.  Thus inflation and deflation are related to both types of supply and demand as they at their core relate directly to the general price index of goods and services in the economy at large.

Deflation vs Inflation

Everyone grasps what inflation is.  You may know it as a cost of living increase, however.  While I will have an article about inflation shortly that goes into more detail, inflation is simply a rise in price as pertains to goods and services.  This is a generalized thing and is often tracked as the average cost of living increase.

Deflation is pretty much the opposite of inflation.  It’s a general decrease in prices.  There are a number of causes and effects of deflation which I will go into shortly.  In the meantime, if you are eyeballing a $100 chain saw at Sears today, and next week it’s $80, that’s deflation.  If instead it’s $120 next week, that’s inflation.   Yes those  numbers are unrealistic and arbitrary but you get my point.

This price reduction (aka price deflation) isn’t such a bad thing if it’s for individual goods and services, but it’s a darn bad thing when it touches the entire economy.

What causes deflation?

There are generally speaking two main causes to deflation.  The first is a reduction of the supply of money or credit.  Remember I talked about supply and demand working for money too?  If the supply of money goes down, the VALUE of that money goes up.  So even if the supply and demand for that chain saw remains the same, if the value of a dollar goes up due to lower supply, the price in dollars of that chain saw goes down.  Deflated price.

Rudy’s Extra Tip: An easy rule of thumb is to recognize that in an deflationary environment your dollar will go farther the longer you hang onto it.  In an inflationary environment the longer you hang onto that dollar the less it’s worth.

The other main cause of deflation is a reduction of economic expenditure.  In other words, people stop spending money.  Back to our supply and demand scenario, if fewer people want that chain saw the law of supply and demand forces that price down.

There is another cause of deflation that is often considered good:  an increased supply of goods.  If the chain saw factory has a breakthrough in efficiency and is able to make more chain saws than they normally would, then that will force the price down as well.  This is often a good thing.

Rudy’s Mea Culpa: If you ask an economist they’ll tell you there are technically four causes of deflation:  decreased supply of money, decreased demand for goods, increased demand of money, and increased supply of goods.  I’m lumping the supply and demand changes of money together as they overall result in ‘tight money’ which means that people want more money than is available.  No, I’m not an economist.  I simplified on purpose!  I hope you don’t mind too much.

What are the side effects of deflation?

DeflationarySpiral (320x231)Well, there’s one big one that might look a bit familiar.  Sky rocketing unemployment numbers.  If the deflationary cause is related to ‘tight money’ or a lack of economic demand for goods and services then businesses often are forced to reduce their workforce.  This usually results in those now out of work folks spending significantly less.  As the economy continues to contract and businesses continue to reduce their work force the problem compounds.

Add into that credit defaults, wage contraction (supply and demand works for wages too!) and even lower demand for goods and services.  Resulting in more economic contraction and less free money being spent. You have the makings for an economic spiral which can lead to a major economic depression.  NOT GOOD.

Woah.  Going from deflation to depression?

Sorta.  For a deflationary environment to broadly take over and potentially turn deflation into a depression the key factor that must historically be in place is what we call a credit bubble today.  That basically means a big expansion  in the amount of available credit.  As the bubble gets bigger and bigger things look rosy and fantastic.  Nobody expects default, lenders relax standards and lend to people who have no business with loans.

Pop goes the bubble!

A bank run during the Great Depression

A bank run during the Great Depression

When you have a credit bubble forming the signs are obvious.  The cautious and smart economic thinkers will be able to see the signs clearly, but Joe Public usually doesn’t.  Eventually something bad happens in the economy that sets it all off and starts the bubble popping.

Rudy’s Extra Tip: There are two kinds of credit.  Self liquidating credit is something that is paid with interest in a short time.  Something like a business loan, or an expansion loan, etc.  This kind of loan usually adds value to the economy at large.  Non self liquidating credit is your mortgage, car loan, etc.  A loan that is there to acquire an asset or to speculate.  Basically anything that isn’t tied to direct production of a good or service.  When non self liquidating credit forms a bubble and pops, then deflation is FAR worse.  Sound familiar?

The result of this economic death spiral is a recession or depression, formally known as an economic contraction.  Bad news, Batman.

So what happens next?

The central bank steps in and adds more money to the economy.  This must be done in an intelligent fashion though, which is the key problem.  You can’t fire off a big stimulus package and increase government spending because that generally doesn’t hit the economy very well.  On the other hand, sending out a stimulus check doesn’t work either because people will just hang onto it because they need it for debt or are worried about spending it.  In any case, it doesn’t do much for the economy.  It does start causing inflation though.

PastCrisesG
The key here is to direct that money towards productive uses.  Underwriting self liquidating credit for example is a good one.  Focus on enabling people to generate real value and production for the economy.  Eventually if you inject enough money in the right way the spiral ends and things pick up.

Rudy’s Tip: If you have personal debt, get out as soon as you can.  Deflation hurts particularly bad when you have personal debt.  At very least get out of debt that carries variable interest rates.

The problem is that people often don’t do this the right way.  Enter hyperinflation which I’ll talk about later this week.

See the parallels?

money_pile (320x240)I’m guessing at this point I don’t have to lay it out for you.  In this country we are in a deflationary spiral now which was caused by the credit bubble (NON self liquidating) popping.  Resulting in high unemployment, credit defaults, and the vicious circle.  We now have printing presses running overtime flooding the market with dollars.  And we’re selling more and more government debt.  Neither of which is doing anything at all to right the ship.

Right now cash is king.  The problem is that this will eventually end and we’ll see inflation kick back in.  I fear it will be a hyperinflationary environment.  Yikes.

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Economy: Currency and the Gold Standard

October 9th, 2009

forex22 (320x302)It occurred to me that before I dissect any other economic collapses from the history books I should probably explain some of the basics of currencies and the two types of inflation: Hyperinflation and Deflation. If you already know all of this, feel free to heckle from the back row! On to Currency!

What is a currency?

Simple, right? It’s the money that sits in our wallet, or our bank account, or under the mattress. We use it to buy stuff! In its purest form a currency is something that is valuable or represents something else of value. This could be anything you consider to be worth something. That could be a precious metal, grain, land, or maybe even yak beard clippings. In any case, currency at it’s base simply represents something that is uniformly considered valuable. If you don’t value yak beard clippings, you probably wouldn’t take a piece of carved wood that represents five pounds of clippings in exchange for a meal.

What is a commodity currency?

A commodity currency is pretty much what it sounds like.  It’s something that is intrinsically valuable.  That could be fish hooks, gold coins, or FizBats.  It’s really all about what is intrinsically valuable to the parties involved in an economic transaction.  Typically throughout history commodity currencies have been precious metals (gold, silver, copper, etc) or gem stones.

What is a representative currency?

A representative currency is, oddly enough, a currency that represents something of value but is not in and of itself valuable.  For example if I hand you a piece of paper that says ‘Rudy Kearney will redeem this paper for one gold bar on demand’ then that is a representative currency.  A centrally issued bank note that is redeemable for something of value is also representative.

What is a fiat currency?

A fiat currency is something that has worth because the issuing central bank and the government say it has worth.  As long as participants in the economic transaction have confidence that the government and bank are right in their assertion, everything is fine.  If those participants lose confidence a fiat currency loses some or all of its value.  Most governments require that their fiat currencies are accepted to settle any debt.

Rudy’s Recap: If you hold something that is actually valuable, say a gold coin, that’s called a Commodity Currency. If you hold something that represents something valuable, like a carved stick that represents a gold coin, then that’s called a Representative Currency.  A fiat currency is a piece of paper that is worth something because the bank says it is.

The transition from commodity currencies to representative currencies

T050067A (320x231)Initially most currencies were commodity currencies.  We’ll assume coins made from precious metals though historically speaking just about anything with mutual value (a commodity!) was used as a commodity currency.  It’s great to know that what you have in your hand is actually worth something.  Gives you lots of confidence in it!

If you’ve ever carried around a few thousand pennies you realize that this stuff is heavy. Pretty darn heavy in fact. So consider the fact that ‘back in the day’ you might be running around with coins made from pure precious metals. This could get downright heavy, leading to treasure chests and the like which were somewhat difficult to deal with on a day to day basis and were often pretty easy to steal. While Captain Jack Sparrow was particularly pleased with this, your average joe wasn’t. As early as the 6th century people began printing bank notes on paper, cloth, yak hide, etc.

These bank notes truly represented the gold that could now sit in vaults instead of being carried around. This helped early economies really take off. Paper money is easier to transport, easier to loan, all sorts of good stuff. The problem is that you have to have confidence in whoever was issuing the note. If you held a 100 Yak Clipping note from the First National Bank of Yakville, you AND everyone else had to be confident that the bank actually had 100 yak clippings for you if you ever wanted to turn in that note.

Somewhere along the line people realized that there really wasn’t anything preventing the bank from printing TWO (or more!) 100 Yak Clipping notes and hoping that only one of you came to get the yak clippings. This made people be rather suspicious of bank notes and the like. It didn’t help that governments often let anyone who kissed enough behind to print their own money. Enter Chaos!

Here comes the central bank!

So to address these concerns some clever folks came up with the idea of a central bank. Put a bunch of gold in a vault and they were the ONLY ones who were allowed to issue coins or bank notes for a given currency. These notes were then considered Legal Tender – Good for all debts, public and private. The bank could decide how much currency it would issue per unit of gold it held.

This was a good thing for a long time. Either you had hard currency (a gold coin) or a gold standard based bank note (a bill backed by a gold coin in a vault at the bank). There was just one problem. Pretty soon people printed too much money and couldn’t be backed by gold. So much for a gold standard backed representative currency. Enter the concept of Fiat Currency.

And here you thought Fiat just made cars…

1 (320x213)Fiat currency is worth money because the government says it’s worth money. It’s not backed by any sort of commodity. This means you can’t take a $100 bill and get a $100 gold coin from the bank. Fiat currency is VERY dependant upon confidence. It’s a worthless piece of paper unless you and the other side of your transaction have confidence that it’s worth something.

Since fiat currency has no backing other than faith and credit it is extremely vulnerable to inflationary cycles. Inflation happens when the money supply increases too rapidly. If the money supply increases more than the GDP does, you usually get inflation. You can also get inflationary pressure if confidence drops. Danger Batman!

So why did we drop the gold standard?

2558158691_6e2e39ae67_o (233x320)Good question! Some people claim it was inevitable. They claim that since the supply of gold on the planet is finite, there’s just not enough to go around to cover the money supply. Apparently they forgot they can just turn off the printing press. In any case, that’s the logic behind what happened, right or wrong. History hasn’t been particularly kind to fiat currencies and it’s not looking too well at them today.

Another reason why the gold standard got dropped is that governments across the world issued too many bank notes and too many debt instruments to be able to continue backing them with gold, even on a fractional basis.  By dropping the gold standard you can just print new money willy nilly and pay off your debts with funny money.

I think the biggest reason why the gold standard was dropped is related to control. If you have a 1oz gold piece you know that it’s worth something. As a finite resource it has inherent value. YOU control that value and you know that someone else can’t wave a magic wand and devalue that gold coin. With fiat money the central bankers can arbitrarily choose to add more money to the system here and there. They control the value of the $1 USD note. The more money that’s in circulation the less every dollar is worth. It’s a vicious cycle. And you and I are at the whims of the central bankers. Not a happy place to be.

So what’s next?

Monday I’ll have another article for you guys to read describing the death of a fiat currency: Hyperinflation. I’ll cover deflation in that article as well. I hope you all come back to read it!

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