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THE
ROCKET SCHOOL OF ECONOMICS


The Broken Watch -- Part 2.
by Professor von Braun

March 31th, 2008

fiat money: Money that is not convertible into coin or specie of equivalent value and thus is dependent for its value on the decree of the government.

Webster's Third New International Dictionary

The inherent and fatal flaw in the fiat monetary system is the often overlooked fact that the debt issued in fiat can never be repaid. For the debt to maintain the resemblance of being debt it has to be continually expanded and old debt is recycled as new debt ad infinitum, creating ever more debt and inflating the price of any assets that the debt is issued upon.

There is no end game to this activity other than an eventual total monetary collapse which sees the debt become worthless. The inflation of prices turns into the deflation of prices of the very same assets and the inherent flaw is exposed.

In other words a debt can not be repaid with another debt, since by definition there is no repayment. Since the currency can not be redeemed officially for anything at the point of issue it, in and of itself, is a quasi debt instrument, albeit one that is widely accepted as a means of temporary settlement, but it is not a neutral non-political item. Gold traditionally has served that role, supported by silver and, to a lesser degree, copper. They were traditionally the widely-accepted form of final settlement for goods and services and for the ultimate repayment of loans.

What we have today are a collection of central banks that operate on the basis that nothing ever needs to be settled, that printing more 'money' is the solution to any requirement to settle, and that the actual value of that 'money' will never be questioned.

What is the value of the US dollar? Currently with gold at $930 an ounce its worth 45 times less than it was in 1930 when gold could be purchased for $20.67 per ounce. Alternatively one could swap an ounce of gold for $20.67 in paper and coin, whereas today one would receive $930.00 worth of the same paper.

To talk about unproductive asset prices increasing in value is ridiculous. What is happening is a decrease in the purchasing power of the currency itself. This is called debasement, an activity widely practiced by the Romans with the addition of lesser valued metals to their silver coins to the degree that eventually the coins contained 2% silver, down from a 100%, a 50 fold decrease in actual value. At that point to get an ounce of silver one would now require 50 of the debased Roman coins.

The recent run up in the gold price to $1033 equates to a 50 fold decrease in the purchasing power of the US dollar, a figure that reflects the Roman situation prior to the collapse of that empire.

Can central banks, with some assistance from governments, create a prudent means of final settlement other than gold and silver? Is it possible?

If history is our guide the answer is a resounding NO! Previous attempts, including a couple that carried the death penalty for refusing to accept the paper, all have one thing in common -- they failed. And what we are seeing now is the beginnings of the failure of this latest attempt.

When a point is reached that sees the banking system unable to recycle the debt then the reverse of the method used to keep the game going begins. Inflation of asset prices brought about by the need to recycle the debt-that-can-never-be-repaid becomes deflation as the inflated prices return to previous levels.

Once the purchasing power of the currency is seen to be declining, people, the local citizens, begin to accumulate hard assets and at a certain point they begin to withdraw their deposits from the banking institutions, creating a liquidity crisis for the banks themselves. This is the point that we may have arrived at since the banks are now unable to sell their loan portfolios to come up with the cash required to meet the depositors demands for withdrawals.

This point also is the equivalent of an old fashioned bank run, which given the events over the last few weeks is what all Central Banks are, apparently, working overtime to avoid at all costs. Why?

Because it signifies the beginnings of the end of the fiat system and it's back to the basics, as in settlement is required, and we need to remember that you can not settle a debt with another debt. You can defer settlement with another debt but eventually settlement will have to be made.

This was the danger of fooling people into believing that their home equity was their savings and that was all they needed. But taking out another debt to settle an already existing debt has its price and it is not settlement. When real estate prices begin to decline and continue to decline, then its bye-bye home equity which equates to: bye-bye 'savings.'

This compounds the home loan lenders problem, since most of the consumer loans are, directly or indirectly, 'secured' by real estate. The largest portion of all bank lending is in real estate, not that it matters too much since other sectors of the economic circus are dependent upon the consumer for their income and the consumer has no savings left.

By no stretch of the imagination should people believe that Central Banks and their respective governments can fix this. On the contrary, investors that are debt fee should be following the advice of experienced advisors as Richard (www.dowtheoryletters.com) Russell, who advises his clients to hold gold, cash and a mortgage-free home.

To hear the US Treasury Secretary talk about the US having the most efficient capital markets in the world conveys the basic misunderstanding currently being practiced by all central bankers which is the erroneous idea that debt is capital. Debt is not capital! What he should be saying is that the US debt markets were once the most efficient in the world -- but now they are problematic!

Applying new regulations to a worn-out, overextended, debt-riddled financial system will not fix that system, and as long as central bankers persist with the idea that money can be created out of thin air, the inherent problem, that of no settlement, will remain.

The widespread practice of encouraging the citizens of western world countries to increase their debt levels to keep their respective economy ticking over is an insidious activity that can not continue.

In addition, to hear Hank Paulson say that people who could afford to pay their home mortgage but were walking from the obligation are speculators is itself an absurd statement. Why would anyone whose home equity 'savings' are gone want to continue funding a rapidly depreciating asset?

Inflating real estate prices does not equate to productivity, it merely allows for debt to be recycled and the burden of repayment of something that can not be repaid is passed on, albeit temporarily.

All promises to pay, regardless of what they are, whether they be pensions, medical benefits, debts between banks, or debts between countries can not be settled by issuing more debt.

The idea of an unlimited money supply being available via a printing press is part of the fiat problem!


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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