2011 – The year when money starts to die

Alasdair Macleod – 5 January 2011

Between 1716 and 1720, John Law tried to rescue the French government from bankruptcy with a scheme that came to be called “The Mississippi Bubble”. His strategy was to set up two entities: a bank whose purpose was to issue paper money, and a company whose primary but undeclared function was to refinance government debt. Law realised that he had to confiscate all gold and silver other than smaller quantities, and force French citizens to pay their taxes and buy shares in the Mississippi Company, only with the bank’s newly issued notes. These were the three essential elements of his scheme.[i]

This is precisely what central banks in the US, Europe, Japan and the UK are doing today. They are rigging the markets by buying government debt at artificially high prices with freshly created paper money, having previously excluded gold and silver from any role as legal tender. The following quote from John Law, could equally be attributed to a central banker of today: “An abundance of money which would lower the interest rate to two per cent would, in reducing the financing costs of the debts and public offices etc. relieve the King.” This is quantitative easing, pure and simple, and John Law had fully anticipated modern central banking. Law’s scheme ended in disaster and as a precedent for today’s central banking this should worry us greatly.

Many of us recognise the government debt bubble, which ensures that today’s rulers are relieved by the artificially low cost of their debt. But most of us are unaware of the other bubble, that of the value of money, which is also held up at artificially high levels. The money bubble is inflating primarily in quantity rather than price, making it easier to deceive the public. There is also a fundamental difference from the usual bubbles, which end with a collapse while money’s value is unaffected: in this dual bubble both debt and money will eventually collapse together; the former as nominal yields rise and the latter being reflected in rising precious metal prices.

In Law’s time, it was made illegal to hold more than a minimal quantity of gold and silver coinage. Today the central banks have had a different approach, removing gold and silver from circulation altogether. Naturally, central banks have also convinced themselves that precious metals are now redundant, fully replaced by paper money, so they have carelessly reduced their own holdings to suppress prices. At the same time commercial banks offering gold and silver accounts have developed large uncovered liabilities with their customers through their fractional banking practices. Through these uncovered, undeclared positions, the strategy of depressing bullion prices has become dangerously dependant on confidence remaining in both the central banks and the banking system.

We can expect the collapse in money values to be reflected in gold and silver prices rather than other paper currencies, and the warning signs are now upon us. Bullion has been climbing in value for a decade, and in 2010 buyers found it regularly difficult to get physical metal delivered to them by the banks. It is becoming clear that the ability of the central banks to keep a lid on bullion prices is at last coming to an end.

And it is not just bullion prices getting out of control. In the last three months the yield on government debt has risen in spite of fresh rounds of monetary inflation. Markets are now becoming wary of future currency issuance to support the government bond markets, and they are beginning to question risk, rather than value stability. We are learning how it must have felt in Paris in the early months of 1720, when the Mississippi Company share price, as proxy for government debt, began to fall. And if the last few months of 2010 marked the beginning of the end for today’s government bonds, this new year of 2011 will mark the beginning of the end for paper money. The two bubbles are now fully interdependent.

This is why we might call 2011 the year money starts to die. The central banks are beginning to lose control over bubbles one and two, and also bullion. The destruction of private sector savings has coincided with expanding budget deficits so the expansion of the money bubble will have to continue to contain the situation, because there is no alternative. As monetary inflation translates into price inflation, government bond yields will rise again, developing into a self-feeding loop of government bond prices and currency purchasing-powers falling, as the prices of commodities and raw materials rise further. This process is already underway.

Rising price inflation should lead to rising interest rates, which will be unwelcome to the bubble inflators. Higher interest rates will wreck what is left of government finances, and lead to substantial losses for the banking system as well, due to the impact on the economy and asset prices. Suddenly, there will be negative feedback loops everywhere. That is what John Law discovered through the summer of 1720, and it is safer to expect history to repeat itself than not.

This time, the implosion of government debt and paper currency values will not be confined to the destructive popping of the Mississippi bubble. The bubbles today are global and taken together are far bigger. The values of specie are greatly suppressed today[ii], which was not the case in John Law’s time. The adjustment, when it comes, should be far sharper, even catastrophic as a result, and the loss of confidence sudden. It will confound those who trust in a mechanistic link between the quantity of money and the general price level. It will wreck the Keynesians’ cherished experiment with expanding deficits as a means of economic regeneration. It will destroy the central banks. It will be a poor consolation that these last two consequences will at least be a pyrrhic good.

Now, the New Year, reviving old desires, the thoughtful soul to solitude retires. It is the time for investment strategists to dream their forecasts, which are invariably optimistic. But there is only one question to ask of these soothsayers, and that is the fate of the two bubbles, and the suppression of gold and silver prices. Will it all unravel in 2011?

Maybe, but if money does not actually die this year, this is the year money starts to die.


[i] The financial aspects of the Mississippi Bubble are best described in Douglas French’s book, Early Speculative Bubbles and Increases in the Supply of Money, published by the Mises Institute.

[ii] See Financeandeconomics.org: Dollar to gold ratio (1 Dec 2010)

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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