Expert Commentary

The Dollar: Gold, Scrip and the Inflation-Deflation Debate

Until 1933, a dollar was defined as a certain amount of gold. Even the Fed's notes were convertible into gold. Money was stable.

From 1933 to 1971, the dollar was still at least partially an IOU for gold, because foreigners could collect gold-price-fixed by the government at $35 an ounce -- from the Treasury in exchange for dollars. Charles de Gaulle of France realized how stupid the U.S. government was for holding gold below its real value and continually cashed in on the deal in the late 1960s. In 1971, the government finally reneged on its debts even to foreigners.

Since then, although each paper dollar issued by the Fed is labeled a note, it is not a note for anything. Today's dollar is just scrip. Nevertheless, U.S. citizens are required by law to use the government's scrip as a unit of account. This situation makes it easy for the government and its central bank to hide the financial and economic destruction their policies have wreaked. They do it by issuing more scrip and IOUs for scrip and more recently by also passing laws to shift the burden even of the largest private debts from wealthy, reckless creditors onto innocent savers and future earners known as "taxpayers." This dual offensive (in two senses of the word) has lowered the value of each dollar and kept what would have been unpayable debts in the system.

Financial commentators believe that the Fed will be able to print enough of its scrip, and buy up enough IOUs for scrip, to ensure inflation or even runaway inflation. This outcome would be assured if the U.S. monetary system were like Zimbabwe's and the government produced all the country's money on a printing press. But the U.S. has a mature debt-money system, and investors in debt -- including IOUs for scrip -- can demand higher interest rates if they perceive inflationary destruction of the units of value they are owed. Every economist knows that the prevailing nominal interest rate is the real rate of interest plus the inflation rate. Investors were so attuned to inflationary pressures in the 1970s that they demanded the government pay 16% interest on its Treasury bills. If the Fed were creating massive net inflation, that's what investors would be doing today. But the Fed so far has succeeded only in replacing bad debt with new money, keeping the sum of debt and debt-money down only slightly instead of a lot. That's why interest rates on T-bills are at zero:

Demand for loans is nearly zero, pushing the real rate of interest to zero, and the inflation rate has been about zero since 2008, according to the total amount of dollar-denominated debts in the system. Many economists declare that the only reason rates are near zero is that the Fed is forcing them to that level. But the Fed cannot create magic in that way. The reason the interest rates on T-bills are at zero is that investors are content with that rate of interest.

In my view, they are content with it because the deflationary mindset -- which leads to caution, conservatism, careful creditors and debt retirement -- is more deeply in place today than it was in the heady years of 2006-2008.

If there is one message I receive daily, it is that I am blind for not seeing that the Fed will just print, print, print and that hyperinflation is inevitable. These messages increase in quantity and stridence whenever stocks or commodities rise, and they reach peak levels when the financial markets are also peaking. Rising markets convince people that the Fed is hyper-inflating. But in late 2008 and early 2009, nearly everyone abandoned this belief and started being afraid of deflation. They will abandon their belief again during the next market downturn. The only reason the Fed appears successful at inflating now is that in 2009, the trend of social mood turned back toward the positive at Primary degree. Don't forget, EWT predicted in April 2009 that by the time the rally was over the economy would be expanding, the Fed would appear to have saved the monetary system, and optimism would return. This is exactly what has happened. It is another testimony to the predictive value of the socionomic hypothesis that it has happened. This positive trend in social mood has reduced fear, induced investors to speculate and prompted business people to stop contracting their businesses and begin making more optimistic bets.

This change has let the Fed get away with appearing to be in charge of the trend. We also showed, in April 2010, that the 7.25-year cycle turned up in 2009, and it is still up. It is due to roll over in late 2012, but as EWT has said several times, prices are likely to turn down well ahead of the center of the cycle. They probably already did peak, in April 2011. The next big downturn will erase everything the Fed and the government have done in attempting to keep the system liquid.

The Fed is truly powerful in having monopoly powers to issue unlimited free credit, but borrowers take advantage of that credit only when their mood is positive. The Fed also has substantial ability to take on other people's debts, but this policy will succeed only as long as the debts it takes on retain their full value. And the only reason the Fed has been able to take on all the debts it has is that the federal government has guaranteed them. But it will not guarantee everyone's debt; voters are fed up with bailouts and the fat cats who benefit from them. That's one reason why Ron Paul is showing better than pundits expected in the Republican primary race. When the next downturn occurs, debtors will start defaulting, today's good debts will become riskier, and the Fed will almost surely cease buying so many IOUs. Even if I turn out to be wrong about these things, if at any time the Fed were to try to generate net hyperinflation, investors would demand higher interest rates and choke off the attempt. I still don't see any way out but a deflationary crash.