Richard Duncan: The Most Important Story in All of Finance

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The Most Important Story in All of Finance
By Richard Duncan, Editor, Macro Watch

The classical gold standard existed up until the time of World War I. At that point, all the European nations went off the gold standard because they didn't have enough gold to fight the war.

Under the gold standard, gold was money. So you had to pay for things with gold.

You couldn't have big trade deficits with other countries because you'd have to pay with your gold. After a while, you wouldn't have any more gold… and so you'd stop buying things from other countries.

But during World War I, European governments went off the gold standard… printed a lot of paper money… and used it to finance the government debt.

This led to the giant worldwide credit bubble we call the Roaring Twenties.

In 1930, the credit couldn't be repaid. The banking system failed. Global trade collapsed. And the Great Depression began.


War Stimulus
Most people don't see it that way, but the Great Depression was a direct result of going off the gold standard… and the credit bubble that occurred when we went off the gold standard.

The Great Depression lasted until the outbreak of World War II. Then the US government increased the amount of money it was spending.

Government spending increased by 900%. That 900% increase ended the Great Depression. And we had World War II. You know what happened then. Sixty million people died.

After the war the US and Britain – the good guys – won, they wanted to reestablish a global monetary framework. They would have liked to have returned to the gold standard.

But that wasn't possible because the US had almost all the world's gold. And so it wouldn't have been possible for the US to trade with other countries if they didn't have any gold.

So the Allies created the so-called Bretton Woods system. The US dollar would be backed by gold – at $35 an ounce – and all the other countries in the world would either peg their currency directly to the dollar or to gold.

It more or less amounted to the same thing – pegged exchange rates. That's the way things worked from roughly 1945 up until the late 1960s.

The Dollar Standard
At that point, the Bretton Woods system fell apart because the US was no longer willing to abide by the Bretton Woods rules.

Under President Johnson, it started sending too many dollars abroad to finance the Vietnam War. Meanwhile, US corporations were investing heavily in Europe. So a lot of dollars were going overseas and being accumulated by the foreign central banks.

Under Bretton Woods, foreign governments had the right to directly convert their dollars into US gold. They did that. And as a result, during the 1960s the US lost half of its gold reserves.

By 1971, when President Nixon "closed the gold window" – he ended the direct convertibility of dollars to gold – there were four times as many dollars overseas as the US had gold available for those dollars to be converted into.

It was simply no longer possible for the US to allow other countries to convert their dollars into gold. Nixon stopped that. And that international monetary system collapsed.

There were some efforts to create a new gold-backed system after that. But they were unsuccessful. The system that evolved from the ashes of Bretton Woods I call the "Dollar Standard." Because dollars became the dominant global currency.

An Explosion of Credit
That changed everything.

First, it removed all constraints on how much credit banks could create. And after 1971, credit in the US exploded.

As long as you had to have some gold backing for dollars, there was a limit to the amount of gold you had. So there was always a limit to how much credit you could create. Without gold backing, there were no longer any limits.

In the US, total credit expanded from $1 trillion in 1964 to $50 trillion in 2007. So in 43 years, total credit expanded 50 times. And that explosion of credit really built our world.

The other important change was that when we had the gold standard, or the quasi-gold-standard Bretton Woods system, trade between countries had to balance.

Let me give you an example. One hundred and fifty years ago, if Britain had a big trade deficit with France, Britain's gold would have been put on a ship and sent over to France. Because gold was money, Britain's money supply would have contracted.

That would have caused Britain to have a big recession. Unemployment would have gone up. And Britain would have had deflation.

The opposite would have happened in France. France would have more gold. So credit would expand. The economy would boom. And pretty soon France would have inflation.

Soon the rich French people would start buying more cheap British goods. Poor, unemployed British would stop buying so many expensive French goods. And trade would come back into balance again. That's the way trade always worked up until that point.

When Adam Smith and David Ricardo were writing their classical economic theories, their world was a world where gold was money and trade between nations had to balance.

A Return to the 1930s?
Today, the global economy is like a big rubber raft. Instead of being inflated with air, it's inflated with credit. On top of the raft you have all the asset classes – stocks, bonds and commodities, including gold – and 7 billion people.

The problem is the raft has now become fundamentally defective. So much credit has been created that the income of the 7 billion people is insufficient to service the interest on the debt… and they keep defaulting.

When they default, the credit leaks outside of the raft. In other words, the raft is full of holes. And the credit keeps leaking out.

There's a fundamental flaw in the raft now. There's too much credit relative to the income, at least in the way that world income is currently distributed.

The natural tendency of the raft is to sink. And when it sinks – as it did in 2008… and when QE1 and QE2 ended – all asset classes go down together.

Stocks go down… commodities go down… house prices go down, etc. People start to get their feet wet. And they start to panic.

There's only one possible policy response – and that's to pump in more credit.

That's what the QE is about. Central banks pump in more credit. And when they do the raft reflates. Asset prices all go back up again… people have dry feet again… and they're all happy again.

What happens if policymakers completely cut off money printing now and don't step in with some other policy, like more aggressive fiscal stimulus?

The raft would sink just like it did in 1930. We would get sucked into a deflationary whirlpool… the international banking system would collapse… and global trade would collapse.

When that happened last time, Berlin ruled Europe and Tokyo ruled Asia.