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July 28, 2008

The Difference Between Good Money and Bad Money
by Steve Saville

Below is an extract from a commentary originally posted at www.speculative-investor.com on 20th July, 2008.

It is said that the US dollar will eventually reach its intrinsic value, which is zero. This is probably true, but the lack of intrinsic value isn't the main problem facing the dollar and the other fiat currencies of the world. The fact is that money never has any "intrinsic" value, even when the money is gold and silver coin. To see that gold has no intrinsic value, imagine that you are stranded alone on an island with no hope of ever being rescued and consider how much an ounce of gold would be worth to you in that situation. In such a situation you would, in all likelihood, value an ounce of coconut or an ounce of fresh fish far more highly than an ounce of gold.

The value of money is always subjective to the extent that it depends on the preferences/circumstances of individuals, although at any given time the value of the thing chosen as money -- chosen by the market in the case of a free economy or chosen by the government in the case of a 'managed' economy -- can be measured by what the money can buy. This value will fluctuate regardless of the form the money happens to take, but over the long-term the fluctuations in the value of GOOD money will even-out or have an upward bias (the money will tend to increase in value over long periods of time) because the supply of the money will be fairly stable. Not-so-good money, on the other hand, will become less valuable over time due to an increase in its supply. The difference in the long-term rate of change in supply is therefore the primary determinant of whether one type of money will prove to be better, or worse, than another type of money.

Further to the above, even though the dollar is just a piece of paper or a number inside a computer with no physical form whatsoever, it would be a fine currency IF its supply could not be increased. The main reason it and the other fiat currencies of the world are not good forms of money is that their supplies can be increased ad infinitum. And what's worse, their supplies can be increased ad infinitum at virtually zero cost at the whims of governments and banks.

Given the ability to create new money "out of thin air", which can, in turn, be used to buy votes, the average politician will succumb to the temptation to create the money irrespective of the long-term effects of the resulting inflation. In fact, for a politician to be successful it is almost a prerequisite that he/she be prepared to make full use of the inflation tool to garner votes. This will always be the case, which is why it is important that politicians do NOT have this ability. Moreover, the only way to ensure that they don't have this ability is to use money for which the supply is subject to a rigid physical limitation. Gold and silver fulfill this requirement because they are elements that can neither be created nor destroyed by humans. We can change the location of the gold -- for example, by shifting it from below the ground to above the ground -- but we can't create more of it. Furthermore, we can't even shift the gold from below to above the ground without expending considerable resources.

It was the use of gold as money that limited the spending and growth of the US Government -- and protected the freedom of US citizens -- for many generations, even during the 20-year period after the 1913 advent of the Fed. However, a new political modus operandi was put into effect by President F.D. Roosevelt during the 1930s, and due to its proven ability to achieve the primary goal of electoral success (Roosevelt won 4 consecutive presidential elections) this new method of politicking became the template used by both major US political parties from then on. The following excerpts from John Flynn's book "The Roosevelt Myth"(1) briefly describe this method, which although new for the US was an age-old practice elsewhere:

"When first elected, Roosevelt naturally supposed that to spend he would have to tax, which is very unpopular. The alternative would be to borrow from the people and he knew that was difficult. He did not dream of the incredible miracle of government BANK borrowing. He did not know that the bank lends money which it actually creates in the act of making the loan. When Roosevelt realized this, he saw he had something very handy in his tool kit. He could spend without taxing people or borrowing from them, while at the same time creating billions in bank deposits. Wonderful!"

And: "Roosevelt discovered what the Italian Premier Giolitti had discovered over 50 years before, that it was not necessary to buy the politicians. He bought their constituents with borrowed money and the politicians had to go along. Everybody with a halfway appealing tale got money, but on one condition -- that he play ball with Roosevelt."

And: "With the rise of the New Deal...a vast army of persons appeared on the payroll of the federal government and because some of the payrolls were flexible and had no connection whatever with the Civil Service, it was a simple matter for the government to use the ancient but now enormously enhanced tool to control votes in particular localities. Benefits paid to farmers, subsidies of all kinds could be timed in their delivery to correspond with the moment when farmers were making up their minds how to vote. Relief rolls could be expanded in doubtful counties and doubtful districts, and this was done..."

Of course, before he could fully implement his grandiose borrowing/spending plans Roosevelt had to renege on the government's commitment to exchange dollars for gold at a fixed rate and he had to prevent US citizens from accumulating gold (which many of them naturally would have done in order to protect themselves from the inevitable consequences of the inflation).

Economically, Roosevelt's massive government borrowing/spending scheme -- the same sort of 'solution' that many people are advocating today -- was a total flop, for the reasons that anyone with even a basic understanding of economics would appreciate. For example, during Roosevelt's first 6 years in office the Federal Government's debt ballooned astronomically in response to government spending on an unprecedented scale, and yet the number of unemployed in America was higher in 1938 than it had been when Roosevelt was first elected President in 1932. The grandiose spending was, however, a political success, and thus fulfilled its primary objective.

The bottom line is that today's US dollar and its fiat currency brethren are not good currencies and will ultimately lose most, or all, of their value, not because they have no intrinsic value but because their supplies can be increased ad infinitum at virtually no cost. Politicians can't resist the temptation to pander to voters using the 'miracle' of inflation, and, of course, it helps that the average person doesn't yet know or care about the long-term effects of the various spending plans. It also helps that well-respected analysts are calling for the government to spend aggressively to fight the economic downturn.

(1) Although this book was first published 60 years ago it is very relevant today, due to the parallels between 2007-2008 and 1937-1938 and due to the clamouring for a "New Deal" type of solution to the current economic malaise. John Flynn was an excellent writer who closely followed the political and economic developments during the four Roosevelt Administrations. The book can be purchased from the store at www.mises.org.

We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at:http://www.speculative-investor.com/new/freesamples.html.

Steve Saville
Hong Kong

Regular financial market forecasts and analyses are provided at our web site: http://www.speculative-investor.com/new/index.html. One-month free trial available.

Copyright © 2003-2008 Steve Saville

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