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THE
ROCKET SCHOOL OF ECONOMICS


Gold, Bankers, the Trade Deficit and Unsettled Transactions
by Professor von Braun

September 6th, 2006

Part 1.

Let's start with the principle of breathing, which, as we all know, is that for each new breath to be taken, the old has to be expelled. It is impossible to hold ones breath for any lengthy period of time, eventually that 'held' breath will expel itself and a new breath will be automatically breathed in. Fortunately there is no charge for the air.

The working principle of banking is that a) the bank has a paid up capital to begin with and begins to accept deposits from customers, b) customers deposits are then lent out at higher interest rates, c) it is from the difference between what the deposit earns as interest and what the loan earns as interest that the bank makes its income.

Under a fractional banking system the bank can lend out the same deposits several times over, providing that it can find a willing borrower with recognizable security and the ability to repay the loan. Those that police the banking system are always looking at a bank's loan portfolio to see that these requirements are met, that the bank's loans are sound, that the security is there and the repayments are up to date.

The depositor also has an interest in the bank's soundness as he or she would at some stage like his/her money back.

No fiat banking system has ever lasted for any period of time, this we know, and the current banking system that the world is using is, in a sense, another experiment with a fiat system, albeit an unplanned one.

Banking is a means of settling transactions, a convenient way of doing business, of settling an exchange of goods and services between two parties. The world is like one giant swap meet in some ways, were people swap their products for other products or services that help create products or repair them. Trade is not something banking invented. Trade, the exchange of products, led to banking -- a convenient method to facilitate the settlement of transactions when a settlement was required, when the exchange of substances did not balance, when a higher value item 'a' was swapped for a lesser value item 'b' plus some of item 'c'.

Now item 'c' has to be a neutral component, something that is acceptable to all. Historically the component that fulfilled this role has been gold and/or silver. Without a mutually acceptable neutral component free trade cannot readily take place.

Unfortunately it has been the practice of various nations over the centuries to either resort to war when they do not have the ability to trade or to settle any potential transaction, or, alternatively, to debase the item that has up to that time been mutually acceptable as settlement. Eventually the activity of debasement either leads to rebellion, revolution or war.

After these events have taken place the new power possessing being usually re-introduces a substance that is mutually acceptable to all parties as an alternative settlement for transactions, i.e. item 'c.' In fact a key ingredient in well documented past periods of peace and prosperity has been the quality and widespread acceptance of item 'c.'

In 1944 the banking world created the idea that the US dollar would be item 'c' -- that other countries' central banks could hold these US dollars instead of gold and that they could present them to the US banking system and redeem them for gold, thereby maintaining the noble idea that the dollar was as good as gold. The idea of course was that all countries could have access to a mutually acceptable item 'c,' thereby having the ability to settle transactions between themselves with a mutually acceptable component.

How much easier it would be not to have to ship gold they were told and so it came to be.

This 'new' system worked quite well following the end of WW2 through to the late 1950's when an emerging Europe, having rebuilt itself from the previous debacle as a result of trade, began to accrue a surplus of these dollars and, per the 1944 agreement, began to request gold (then priced at $35 per ounce) for these dollars. This began a substantial decline in the US's gold reserves which continued until August 1971 when then President Nixon closed the gold window.

The effect of this was that the connection between gold and the dollar as an official item 'c' was severed. What stability there was in the settlement of transactions along with the ability to actually settle any further transactions 'officially' was gone. Put another way the genie was now out of the bottle.

The great inflation game had begun, quietly, with little in the way of objections from within the banking system itself.

Oil remained priced in $'s as did gold, as did all other commodities, but prices started to rise and rise and rise. By mid 1974 oil was at $10.00 per barrel, silver was at $6.00 per ounce and gold was nudging $125 per ounce. And that was just the beginning.

The process of settling transactions had taken on a different form as countries, central bankers and people conducting business came to grips with the new official non-redeemable international monetary system, which in and of itself is a very non-democratic institution, one that was never discussed, voted on or approved by any entity other than the US itself.

In short the US dollar could be used as a swap instrument providing that the rest of the world went along as it had no official redeemable value, but 'officially' it could be used to pay for goods and services throughout the world, but at a price, as the market set the idea of what it was perceived to be worth by utilizing item 'c' -- unofficially of course as the benchmark it always had been.

By 1980 oil, gold and silver prices had peaked and a stability of sorts seemed to have begun. An acceptance of the situation seemed to have occurred amongst bankers worldwide, certainly by the ones that counted the most, the Europeans, the UK and Japan and they all agreed to hold dollars as reserves, acting as if they were still the same 'convertible into gold at $35 dollars per ounce' pre-August 1971 dollars and continue to treat these dollar 'reserves' in the same fashion through to this very day. The problem they have is that their 'reserves' are US originated IOU's deposited in the US banking system.

Meanwhile the US under Reagan in the early 80's began spending money they merely created -- with the Roosevelt-originated idea of deficit spending gaining momentum with a gusto, and soon the US economy was booming.

But few understood what the boom was all about and how it was occurring. The unrecognized problem was that few were paying any attention to the fact that the US banks were the recipients of the accumulation of its currency by the other central banks who had became the accumulator by default. As trade deficits with the US became the norm the rest of the world seemed happy to continue doing business.

In the late 1990's China had joined the party and today it is the third largest holder of T-bills, following Japan, which follows the collective Caribbean islands -- the offshore tax haven banking industry.

Currently there is about $1.6 trillion held by US bankers within the US on behalf of the other countries central bankers. These amounts are referred to as reserves and it is estimated that 66% of all central banks reserves are denominated in US $'s which means that they are deposited in the US banking system. Now that is rather cute as the cost of doing actual business with Uncle Sam is, to be polite, a tad one-sided. To begin with, the most essential commodities, the ones required for productivity expansion, are priced in US $'s, so the other CB's obviously need to have access to US $'s to fund their own countries' development. But these dollars, the ones referred to as reserves, are deposited within the US banking system itself and it is from these accounts that payment is made.

However
the notes used as payment are debt instruments and are themselves not officially redeemable, which suggests that any accumulation of them is a risky business. They are not a neutral item, on the contrary they are anything but neutral, being dependant on the rest of the world's inflationary banking system to agree to hold IOU's and not hold neutral items.

The US banking system treats a customer's deposits as a liability and their loans are treated as assets and we know that the 'liabilities' can be lent out over and over again.

The other Central Banks treat their US deposits as reserves, but these reserves are lent out again by the US banking system many times over. The effect of the fiat monetary system is to postpone the settlement of any transaction for as long as possible, for that is all it can do. You can not pay off a debt with the creation of more debt, which is what the US has been doing since August 15, 1971 and you can not call a debt instrument a reserve, although that is what the other Central Banks have been doing. They have become depositors within the US banking system, not so much by choice but as a requirement of the banking system itself, the one agreed to in 1944 and drastically curtailed with no discussion or agreement in 1971.

The inherent price of playing this game is inflation, as in particular rising commodity prices. However commodities and the trade and consumption of them is what provided the fiat monetary system with the platform to begin with. It's not so much that the price of the commodity -- any commodity -- goes up, rather it's the decoupling of the settlement unit from its origins (being commodity backed) that destroys its neutrality as a settler of transactions.

Basically no outstanding trade obligations have been settled since August 15, 1971 and the much touted wealth accumulation we hear about today is not other than a collection of compounded book entries that are really quite meaningless and of very dubious value. What the Chinese need to understand is that they are accepting payment for goods produced in a currency that is not a reserve, merely a swap item, which in and of itself creates inflation which appears as rising prices, which in turn shows up in the price of the very commodities China (along with India and other developing countries, as well as the western world) needs to keep the US dominated fiat monetary system going. Remember that in 1971 oil was $3.60 a barrel, gold was officially at $35 and silver was at about $1.60.

In addition the US banking system now has the problem of putting these trade deficit generated deposits to use by way of loans to customers within the US itself -- consumers they call them, who themselves are now largely at a maximum when it comes to their ability to borrow and service their debt. The banking system is running (or has already run) out of things to securitize which has been happening gradually over the last 6 or 7 years with bankers and some select clients now betting between themselves with derivatives contracts, using their clients' deposits to do it with. They are creating ever more and more dubious securities of notional items. The paper gold market is an example of this, where it is estimated that for every ounce of physical traded at a minimum 100 ounces of paper gold contracts are written.

What we are seeing by way of the early fall out from the bursting housing bubble is merely the tip of the debt iceberg. The housing bubble was an attempt to get money to the consumer so they could keep on spending, maintaining the idea that all is well by virtue of consumption figures. This is, in a sense, part of an ongoing effort to avoid the settlement of any trade transactions conducted since the world's reserve currency lost its reserve-ability.

Meanwhile the commodity-rich countries, most of whom don't particularly care for the US, also have to deal with the issue of what to do with their US $ denominated deposits which are also deposited within the US banking system.

Currently I believe that now is about the time we see the emphasis on the back-to-the-basics game when it comes to gold, commodities, bankers and unsettled transactions. If you as an investor, being a holder of US $ denominated 'stuff,' do not currently hold commodities, then you are going to be one among many in a very large pool, one that is tainted with redeemability issues that have been postponed and postponed and postponed again and again, for the last 35 years.

The net result is the numbers increase -- as in from billions to trillions -- in terms of debt, debt that can never be settled, as there is no official mechanism in place to do it with. The only thing left to do is to come up with ever more exotic debt instruments, some of which must work their way through to the consumer so they can continue to consume. Needless to say this will be difficult to do as the consumer is over consumed already, suffers under the weight of personal debt, has no savings and is about to become un-creditworthy.

Put another way, it's time for the US banking system to breath out and resume functioning in a fashion that reflects what a banking system should be -- a means to settle transactions via a neutral item, one that is acceptable to all parties involved.

Finally a quote from Thomas Jefferson:

"If the American people ever allow private banks to control the issuance of their currencies, first by inflation then by deflation, the banks and corporations that will grow up around them will deprive the people of all their prosperity until their children will wake up homeless on the continent their fathers conquered."

That quote is an example of a warning that should have been followed up on and is quite remarkable for its content, which reflects what we are looking at today. The people are about as deprived of their prosperity as they ever have been since the time that quote was given.


The Prof can be contacted by email at profvonb2@aol.com

Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.

Return to the The Gilded Opinion Index Page

The Rocket School of Economics -- The Lecture Series Index

  • 22 May 2009 -- An Often Overlooked Issue!
  • 28 Mar 2009 -- Problematic Banking Systems!
  • 14 Nov 2008 -- What Exactly is an Asset?
  • 23 Aug 2008 -- Through the Looking Glass?
  • 02 Aug 2008 -- Compounding to the Downside!
  • 26 May 2008 -- Back to Basics Again!
  • 31 Mar 2008 -- The Broken Watch -- Part 2.
  • 27 Mar 2008 -- The Broken Watch -- Part 1.
  • 06 Feb 2008 -- The Financial Equivalent of Faulty Towers.
  • 10 Dec 2007 -- Monetary Systems & Productive Assets.
  • 14 Feb 2007 -- Divorced from Reality
  • 06 Sep 2006 -- Gold, Bankers, the Trade Deficit and Unsettled Transactions
  • 19 Jun 2006 -- When is a Reserve Not a Reserve?
  • 31 May 2006 -- The significance of August 15, 1971.
  • 08 Apr 2006 -- Keep Your Eye on the Ball!
  • 30 Mar 2006 -- What came first?
  • 11 Mar 2006 -- An Unanswered Question.
  • 08 Jan 2006 -- Where have all the projects gone!
  • 11 Dec 2005 -- Gorillas, Rising Gold Prices and Depreciating Paper Currencies!
  • 23 Oct 2005 -- Custodial Risk.
  • 16 Sep 2005 -- An Inherent Flaw.
  • 08 Aug 2005 -- Central Banks and 'Reserves'.
  • 31 Jul 2005 -- Central Bankers, Actors and 'We'.
  • 17 Jul 2005 -- Unintended Consequences! -- Part 3.
  • 07 Jul 2005 -- Unintended Consequences! -- Part 2.
  • 25 Jun 2005 -- Unintended Consequences! -- Part 1.
  • 14 Jun 2005 -- The Two Greater Fools Theory.
  • 03 Jun 2005 -- Real Money, Funny Money and YOU -- Part 4.
  • 30 May 2005 -- Real Money, Funny Money and YOU -- Part 3.
  • 26 May 2005 -- Real Money, Funny Money and YOU -- Part 2.
  • 21 May 2005 -- Real Money, Funny Money and YOU -- Part 1.
  • 09 Nov 2002 -- Carrying a Big Stick.
  • 17 Sep 2002 -- Wishful Thinking!
  • 27 Jul 2002 -- Gold Bugs Beware -- part 2.
  • 10 Jun 2002 -- Gold Bugs Beware!
  • 06 Apr 2002 -- Currencies versus Gold.
  • 26 Jan 2002 -- Bear Market Strategies.
  • 01 Jan 2002 -- 2002 -- A Perspective.
  • 20 Oct 2001 -- The Storm Clouds are Gathering.
  • 30 Sep 2001 -- What to Say?
  • 01 Jul 2001 -- ...Said the Fly to the Spider.
  • 14 Jun 2001 -- Upward and Downward!
  • 28 May 2001 -- Volatility Time, Again!
  • 14 May 2001 -- The Coming Bull Market in Gold Stocks?
  • 24 Feb 2001 -- High Hopes, Wishful Thinking & The Absurd
  • 20 Feb 2001 -- Who Put the Holes in the Swiss Cheese?
  • 22 Jan 2001 -- US Dollar Admits Identity Crisis!
  • 16 Jan 2001 -- Dear George W.
  • 24 Nov 2000 -- The Bubble Has Burst
  • 11 Nov 2000 -- The Media, Bull Markets & the Gold Price
  • 02 Nov 2000 -- Gold Stocks
  • 29 Oct 2000 -- Oh The Tangled Web We Weave ...When We Set Out to Deceive
  • 24 Oct 2000 -- A Mystery!
  • 16 Oct 2000 -- A Peso Here ...and a Few Thousand Pesos There
  • 10 Oct 2000 -- The Unfolding
  • 30 Sep 2000 -- What's Wrong with THIS Picture?
  • 25 Sep 2000 -- Buy Gold Now!!
  • 23 Sep 2000 -- The Times, They Are a' Changing
  • 15 Sep 2000 -- Time WILL Tell!
  • 27 Aug 2000 -- SS "Paper Assets" Begins to Take on Water
  • 06 Aug 2000 -- The Indian Summer
  • 26 Jun 2000 -- A Yellow Brick Wall
  • 22 May 2000 -- The King IS Naked
  • 30 Apr 2000 -- Goodbye Yellow Brick Road
  • 18 Apr 2000 -- Beware the Ides of March, April and May
  • 08 Apr 2000 -- Really, Sir Aldot!
  • 25 Mar 2000 -- Where To From Here?
  • 18 Mar 2000 -- The Gnomes of Zurich
  • 12 Mar 2000 -- The "New" Economy??
  • 06 Mar 2000 -- Two Questions
  • 04 Mar 2000 -- Iceberg Dead Ahead!
  • 28 Feb 2000 -- The Wizard of Oz
  • 06 Feb 2000 -- Here We Go Again!!
  • 15 Jan 2000 -- Comments on the Gold Market
  • 29 Dec 1999 -- No Raw Ingredients Required
  • 28 Dec 1999 -- No Way Out
  • 14 Dec 1999 -- Ho, Ho, Ho!
  • 07 Dec 1999 -- Greenspan's Bubble
  • 03 Dec 1999 -- Early Warning Signs


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