How to Understand the Monetary System

Written By: The WealthCycles Staff

The reason the global monetary system survives is largely thanks to the public’s blissful ignorance of exactly how it works. To paraphrase one familiar analogy, if you knew how sausage was made, would you still eat it? It’s probably safe to say that the vast majority of the world’s citizens have no clue that the integrity of the currency they work for, save and use as a medium of exchange every day rests on nothing more tangible than their respective governments’ authority to and solemn promise to tax them in the future.

“It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

--Ford Motor Co. Founder Henry Ford

The first thing you need to understand about our modern global monetary system is that all currencies in the world today are fiat currencies, and all fiat currencies are designed to lose value.

Before Our All-Fiat Currency System

Once upon a time, the U.S. dollar and many of the other currencies now in existence derived their value from the gold stored in national treasuries. In effect, each unit of currency was a sort of IOU to the holder signifying it was backed by a like amount of gold.

As described in Michael Maloney’s book, “Guide to Investing in Gold and Silver,” before the Federal Reserve was created, each U.S. Treasury note (paper dollar) was fully backed by gold or silver. When the Federal Reserve Act was passed in 1913, the amount of gold backing each dollar was reduced to just 40% of the face value of existing currency. In effect, this allowed the U.S. government to increase the amount of currency it could create and spend by 60%, enabling deficit spending for World War I and the accompanying increase of the currency supply.

Then, in 1934, the U.S. government devalued the dollar by 41% by raising the price of gold from $20.67 per ounce, the price established in 1834, to $35 per ounce. This revaluation of the dollar raised the value of the gold held at the U.S. Treasury, so that it once again matched the total value of base money, or all the dollars then in circulation. In effect, the U.S. dollar was once again fully backed by gold. For many years, the governments of the world’s developed nations more or less cooperated under the Bretton Woods international monetary system—to keep the price of gold at $35 per ounce by selling gold into the open market.

Under the Bretton Woods system, the U.S. dollar was designated the world’s reserve currency. Most other nations pegged their currencies to the dollar, and the U.S. in return agreed to redeem U.S. dollars in gold at the rate of $35 per ounce. Under Bretton Woods, the world essentially was on the “Dollar Standard.”

But the Bretton Woods system turned out to be not up to the complexities of a modern global economy. The currency supply was once again inflated to fund WWII, Korea, Vietnam, and President Lyndon B. Johnson’s social programs. America’s foreign policy increasingly meant spending lots of dollars in other countries on foreign aid, defense and military spending and international investment and trade. As a result, lots more dollars flowed into the treasuries of other nations, and much less capital flowed back into the U.S. Treasury, resulting in imbalances.

From the 1950s on, the U.S. government and the Fed undertook a series of interventions in the free market designed to bring the U.S. monetary system back into balance. As always ultimately happens whenever authorities interfere with the workings of the free market, for every action taken, there were unintended and usually destructive consequences. Long-term interest rates kept artificially low encouraged foreign borrowing and discouraged domestic investment. To counter

French President Charles de Gaulle, who had a bone to pick with the United States, opposed the use of the dollar as the world’s reserve currency. France began buying up dollars and redeeming them in gold, seriously depleting the supply of gold in the U.S. Treasury.

As described by HistoryCentral.com:

“By the end of the 1960s, it was clear that the ills plaguing the international monetary system and the American dollar would have to be addressed at a basic level. The Kennedy and Johnson Administrations had applied solutions to the mounting balance of payments crisis that were at best patch-up jobs, postponements of the inevitable. The balance of payments was off-balance, the dollar was overvalued, inflation was picking up speed, and the United States could do little to restore economic order without compromising major aspects of domestic and foreign policy.”

In the end, the United States was not able to meet its commitment to the rest of the world under the Bretton Woods system to keep the U.S. dollar pegged to gold at the rate of $35 per ounce. The bottom line is that Bretton Woods did not allow the United States the “flexibility”—read the ability to create as much currency as it needed—to fund its foreign and domestic policy goals.

By 1971, the United States was essentially bankrupt; it did not have enough gold in the Treasury to redeem all the dollars in circulation.

That year, President Nixon severed the link between the U.S. dollar and gold. With his act, in effect, every currency in the world—thanks to the dollar’s status as the world’s reserve currency—became fiat currency.

Now, fiat currency is not backed by gold or any other tangible asset. The only thing backing fiat currency is the good faith of the people—faith that the value of the currency will be sustained by a government’s future taxing of its taxpayers. As Michael Maloney wrote in his book:

“A fiat is an arbitrary decree, order, or pronouncement given by a person, group, or body with the absolute authority to enforce it. A currency that derives its value from declaratory fiat or an authoritative order of the government is by definition a fiat currency. “

Now unencumbered by U.S. and world monetary policy, the free market bid the price of gold up until, in 1980, when gold reached $850 per ounce before falling, the value of the gold held at the U.S. Treasury exceeded the total value of base money—the total of dollars in circulation—plus all the dollars existing in the form of outstanding revolving credit.(For more information about pressures that drove gold back down, see the WealthCycles.com article, How The Hunt Brothers Capped the Price of Gold.)

At WealthCycles.com, we measure the amount of currency in circulation by adding the number of dollars in circulation and in bank reserves (base money) to the total of dollars represented by outstanding revolving credit, which is mostly in the form of unpaid credit card balances. That’s because, whenever you charge a purchase to your credit card, in effect new currency is created in the amount of your charge. That new currency stays in circulation until you pay off your credit card balance. In many ways credit cards are replacing cash as a medium of exchange and must be included in measuring the total cash, and its digital equivalent, in our modern-day monetary system.

 Shaky Foundation of Modern Monetary System

But in all likelihood, 99.9% of the world’s population doesn’t have a clue about the shaky ground on which the world’s monetary system, our fiat currency system, rests. Many people still believe that the U.S. dollar is backed up by gold sitting in a vault at Fort Knox. Most have no idea that the only thing that backs every currency in the world right now (including the U.S. dollar) is debt and the solemn promise of each government to tax its citizens in the future to pay that debt. In the United States, this promise is called a Treasury bond.

“Should government refrain from regulation (taxation), the worthlessness of the money becomes apparent and the fraud can no longer be concealed.”

 --John Maynard Keynes in Consequences of Peace

However, the overwhelming ignorance and confusion about how our monetary system works is changing. The global Financial Crisis shook things up, got people’s attention, forced many people to take a closer look. In our information society, the public is becoming educated faster, and knowledge is spreading quicker, than at any time in history. And as the information gets out there, people’s faith in all currencies, especially the U.S. dollar, will be shaken to the core.

Today we are hearing a lot about currency wars, as nations such as China continually devalue their own currencies in order to keep them low in relation to the dollar. Every country wants a weaker currency because a weaker currency helps their exports and GDP figures. By weakening their currencies, governments are able to keep the prices of their goods low, making them more attractive to foreign buyers. The United States’ devaluation of the dollar via currency creation in effect forces other nations to devalue their currencies as well. It is political death to have a strengthening national currency in a world of fiat currency debasement.

There remains a serious looming threat of national currency protectionism, with possible showdowns between western and eastern blocs. It almost looks as though the first currency regime to establish gold again as its anchor may become the world's reserve currency, as the world will flock to the stability that only gold can provide—as has happened repeatedly throughout history.

In a November 2010 article, the Economist cites Belgian economist Robert Triffin in describing the growing international conflict over monetary policy:

“Consider, for instance, the tension between emerging economies’ demand for reserves and their fear that the main reserve currency, the dollar, may lose value—a dilemma first noted in 1947 by Robert Triffin, a Belgian economist. When the world relies on a single reserve currency, Triffin argued, that currency’s home country must issue lots of assets (usually government bonds) to lubricate global commerce and meet the demand for reserves. But the more bonds it issues, the less likely it will be to honour its debts. In the end, the world’s insatiable demand for the “risk-free” reserve asset will make that asset anything but risk-free. As an illustration of the modern thirst for dollars, the IMF reckons that at the current rate of accumulation global reserves would rise from 60% of American GDP today to 200% in 2020 and nearly 700% in 2035.”

The world economy is at the brink of a deflationary spiral. Governments and central banks are taking desperate measures, flooding the global economy with currency in the form of stimulus packages, bailouts, deficit spending and cheap credit, in an effort to ward off deflation.

If the future economy is bad, if growth remains stagnant or declines, as is likely, it will become increasingly, if not impossible, to pay off the debt that backs each unit of. If you look beneath the surface, the strength of the U.S. economy and the financial position of the U.S. taxpayer look shakier than at any time in history. The official U.S. national debt today is $127,000 per taxpayer, and when you add in consumer debt, mortgage debt, and credit card debt, it brings the total to more than $500,000 in debt for each taxpayer. If you throw in the United States’ unfunded liabilities, such as Social Security and Medicare, the total comes to more than $1 million in debt per taxpayer. None of these numbers is sustainable, especially when there are 26 million people in the U.S. who are unemployed or underemployed.   

Gold’s Firm Foundation

Although we have no empirical data before the establishment of the U.S. Federal Reserve, it appears that the free market has periodically revalued gold—increasing its value to account for the excess currency in circulation—time after time, for the past 2,400 years.

The lessons of history tell us that the free market will bid up the price of gold until the value of the gold held in government treasuries is once again in equilibrium with the value of circulating currency. With a world economy more interconnected than ever before in history, and with every currency in the world now fiat, we can expect the free market to push gold prices high enough to account for all the currency now circulating in the world. If this happens, it will be nothing unusual… It will just be history repeating itself. When you look at the relationship between gold and the circulating currency media over long periods of time, they don’t just appear to be interrelated, they appear to be conjoined. Two sides of the same coin, so to speak.

Gold and silver have been rising against all national currencies since 2005. Over the long-term, inflation is inevitable, as governments and central banks implement inflationary policies such as quantitative easing and lowering the cost of debt, in order to avoid deflation. The more currency that is floating around, the higher the prices of precious metals can be expected to rise. That’s because throughout history, every time a nation has debased and finally destroyed its currency, the free market has chosen gold and silver as the ideal money.

But the massive expansion of currency supplies around the world has created conditions ripe for a currency crisis of massive proportions. Ultimately, gold will not only benefit from the massive expansion of the currency supply, but it will also benefit from the global currency crisis that lies in wait.     

During these crises, it is nearly certain that holders of precious metals will be the beneficiaries of the wealth transfer that will occur as the entire globe rushes into the safe-haven asset. The coming rush to gold and silver will be a completely different type of bull market, because not only will you get the buyers who are looking for opportunity, but you’ll also get people panicking to simply salvage some of their wealth. The monetary crisis will offer a once-in-a-lifetime opportunity that will benefit from both fear and greed at the same time.  In fact, I believe will be the greatest opportunity in history.

Gold and silver rising in value against fiat currencies is inevitable.  As Michael Maloney wrote in his book… “It is as certain as the sunrise.”

MIKE MALONEY IS THE NEXT PRESIDENT OF USA.

Yes ...

The single most important element in the monetary system is never mentioned in this article and that omission brings into question both the accuracy and the motive of the writer. He never mentions banks. Additionally, all new currency is placed into the economy via banks. It is printed by the government in the case of dollars but dollars are issued into the economy by privately owned, for profit organizations called banks, not by the government.

Hello,

In the last yellow sticky note we mentioned banks.

Earl

Chris Martenson uses the "classical" definition of money:

Money should possess three characteristics. The first is that it should be a store of value. Historically, gold and silver filled this role perfectly because they were rare, took a lot of human energy to mine, and did not corrode or rust. By contrast, the US dollar pretty much constantly loses value over time – a feature which punishes savers and enforces the need to speculate and/or invest. A second feature is that money needs to be accepted as a medium of exchange, meaning that it is widely accepted within a population as an intermediary within and across all economic transactions. And the third feature is that money needs to be a unit of account, meaning that the money must be divisible and each unit must be equivalent.

The second feature, that it serve as a medium of exchange, is the only essential feature. Money is only a store of value by accident. Most money through history has been inflated / debased. That is a natural consequence; thus "money" is not what you should generally use as a store of wealth.

Gold backed "money" is an historical oddity. Money is whatever people agree it is. That requires trust. Gold is useful, in that it is difficult to counterfeit.

fofoa.blogspot.com has a lot of pro gold essays.

But gold is not and only rarely is "money"

Can it be a store of value? Yes

This article makes the rookie mistake of assuming that "money" means there is a debt to be paid.

it will become increasingly, if not impossible, to pay off the debt that backs each unit of. If you look beneath the surface, the strength of the U.S. economy and the financial position of the U.S. taxpayer look shakier than at any time in history.

The US owes its debts in dollars. The Treasury has an unlimited supply of dollars. The US does not need to borrow in order to spend; the reason we issue debt is to manage inflation and interest rate risks, not to "raise money". note that this applies only to sovereign issuers like the US (UK, Japan etc), and the US is currently special because the dollar is the worlds reserve.

The US can always "pay its debts", the issue is the inflationary consequence.

I'm sorry, but this piece of writing was nothing new to me.

I am just one of the "common" people, who assumed ( incorrectly) that the elected officials were there to provide protection and direction for the "working class".
It has become clear recently that GREED and VANITY have much more to do with the directions being taken. It seems that is all based on the fact that we will be taxed FOREVER to provide the "fiat". Disgusting

Thanks to Mike and the team I am helping others wake up from their dreams and wake up to reality. It's a challenge to inform but not to over feed. One step at a time to understand the truth of our matrix. Thanks again to Mike and the team for empowering us and leading us to the other side!

The market will win.

But the longer the government and the banks struggle against the market, the more painful life will become for the citizenry.

Thank you for the article! It was very informative and gave me a clearer understanding of what is going on with our monetary system. Its also clear that gold and silver are more than just commodities. What else can I learn from this site?

All you need to learn is to always posses things that have their values within themselves (gold, silver, rice, sugar, salt, lands, animals). Paper has no value except to write on it or to be used for packaging or for decoration.

I would have to say that mike and the guys at wealth cycles have placed the final piece in the puzzle i figured out in early 2008. That our free market system is an illusion because the currency we all use isn't free from manipulation. The understanding of this was a watershed in my life. In early 2008 before the crash i asked myself a profound question where does money come from? That lead to the federal reserve a private corporation! I knew already that they set intrest rates for the nation and the market went up or down on there announcements, but what i didn't know is that our goverment had outsourced money printing to them and that to get dollars they had to borrow them! That lead to a self taught course on the meaning of inflation/deflation, and that allowed me to see the fraud of the scheme we all live under. In the bible they say debt equals slavery so that means anyone who works for dollars(debt) is a slave! Although I could anticipate and keenly understand what inflation means to its core for all of us it was hard for me to know true value of assets. Trying to find value in a falling asset the dollar only allowed for me the ability to know what investment class to be in not when to get in and when to get out with pin point accuracy. Finding true value in asset versus asset allows for me that pin point I never had. Thank you guys so much! Funny because I have no formal education like mike, but my passion resides in the complex study of human nature(heard mentality), value of assets, and time! When i stumbled upon mike Maloney in the summer of 2011 it was like meeting an old friend that I never knew. His understanding of very complex systems is much like my understanding of complex systems. After showing some video's to friends and family this summer they would exclaim wow this guy sounds just like you. And I would say yes but he gave the priceless piece of the puzzle I so desired finding "true" value!

Hi I am new but found all these info disturbingly true.
If the government can manipulate currency, then all other free market eg. Stock, commodity, oil, other currency can also be manipulated likewise, since most governments have a magic money printing machine and magic account that won't run dry. Any investment would be akin to betting our hard earn money against their virtual dollar. I hope more people will join in this rally to overcome the manipulative force.
Speed up your good works in educating public on economics
Suggestion : lower your subscription so more people can have access.
Cheers

Hi Kong,

We appreciate that you enjoy the content! We hope others will be aware of the current monetary system as well.

Earl

 

Wow. Just wow!

I learned more in that article (along with reading against other resources) than I did in my college level economics symester!

Thanks again for such great information.

C.B.

It would be an incredible resource and feature for this site to provide historical prices (in excel) for gold, silver, crude oil, DJIA, food, etc. so customers of this site can make their own charts, graphs, and measurements of "value." Love the site already and great source of information.

We are getting there... The team is planning for a launch of Chartland this year... More details coming soon. 

well written article, I appreciate the fact you put it out their in laymans terms, easy to understand. My thanks.

"In our information society, the public is becoming educated faster, and knowledge is spreading quicker, than at any time in history."

Thanks Mr. Maloney and Wealthcycles-Team for making your tremendous contribution to this!

Thanks smoothbrother,

We do our best to deliver the best content we can. We are glad you like it. 

nicholas - WealthCycles Administrator

We had a drop in price on silver and gold recently. As you taught us we should look at gold and silver value and not the price. How can i as example measure golds value in oil?

Hello Josefsson,

WealthCycles is planning on introducing a new feature where you will be able to do exactly that. This should be coming in the future. There are also some good paid services out there.

You can also just type what your looking for into google and find a decent chart. Google something like gold oil ratio.

nicholas - WealthCycles Administrator

Great article, thanks again.

My wife was in agreement but had a problem, asking- how do you know they cant continue to paper over the problems for a considerable period of time yet? ie, how would I know they cant remain insane longer than my day-job lasts?!

Hello mumstheword,

Your wife has a great point. There were people back in the 1970s saying the inflation was going to kill the dollar and yet we still have it.

Our main point to get is that free market forces eventually win out. No matter how long some men try to manipulate the will of free market eventually the market will win. That is because the market is an aggregate of the thousands of decisions billions of people are making. Trying to control that is, in our opinion, an battle they cannot win.

nicholas - WealthCycles Administrator

Your wife is right...You can't time the $US demise and perhaps it will never happen. But given just the facts of overwhelming debt and the amount of $US being printed, I'm betting things won't turn out so well. Either way, it pays to be prepared. ;)

testiomials If history repeats itself—and it always has—the free market will push gold prices high enough to account for all the fiat currency now circulating worldwide.”

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