Currency collapse dynamics

Alasdair Macleod – 19 May 2012

The reason we accept paper money as a store of value is habit. This habit has its origins in history, when banks took our gold as deposit and issued paper receipts for it. The gold has gone, but the paper with its habitual value remains, and we accept it without question. The only backing is a vague government promise.

There is no sound theoretical basis for why unbacked government-issued money should retain a store of value: it depends for its value on a market-based acceptance of financial credibility. So it follows that if a government loses all financial credibility in markets, its paper becomes worthless. This is confirmed by experience in all paper money collapses.

The fact it can and has happened elsewhere confirms that all faith can theoretically disappear from the dollar, pound, euro or yen. This is a very different understanding about currency values compared with what is commonly accepted. Instead, we assume that any change in purchasing power is tied firmly to price inflation, and we factor out any reliance upon faith. But this is a cop-out, a way of not addressing the basic assumptions that uplift the value of government-issued money from zero to what it will actually purchase.

It is vital to understand that price inflation and maintenance of fiat currency premiums are only loosely related. In a sound money economy, an economy where the medium of exchange is backed by gold, changes in the available quantity of money will affect the prices of goods and services exchanged for it. This is because sound money is itself a commodity, whose function happens to be to act as a medium of exchange. However, you cannot say this of fiat money, where the link with value is based entirely on faith. It is a mistake to assume that supply and demand factors that give sound money its value as a means of exchange also apply to unbacked government money. The value of fiat currencies is purely subjective.

In the case of fiat money, additional quantities in circulation increases demand for goods, whose prices rise driven by this extra demand: the rise in prices comes from the goods themselves, and not a change in the value of the money. In stagflation, where there is no extra demand, price rises emanate from changing values in the paper money itself, usually tied to foreign exchange movements.

The implications are profound. To state that in hyperinflations fiat money loses purchasing power because of massive issuance of money is a misunderstanding. The collapse in purchasing power is due to loss of faith in fiat money, and not from its extra supply: if it was otherwise, you would have to establish it had an objective value in the first place.

It is entirely possible, even increasingly likely in these times of growing systemic risk, that a collapse of paper-money values will happen not as a result of rising consumer prices, but of its own subjective value. If this happens there will be little or no warning and it could be substantial if not total.

So the argument in favour of a flight into sound money, best exemplified by precious metals, is getting stronger by the day.

Published by

FinanceAndEconomics

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.

Leave a Reply

Your email address will not be published. Required fields are marked *