Thursday, April 3, 2014

The History of Money

From Money Morning (a very good daily commentary newsletter)

The future of money dominated the World War D conference — but Greg Canavan’s presentation charted the history of money.

His first task was to define money. Why would you define money? It’s just the stuff you put in your wallet, right?

Well Greg gave the audience this simple definition: money = credit = debt. All money created in the economy is simply debt.

Think about it. When you take out a loan, the bank assesses your credibility and then credits your account — money is created out of thin air. It happens on a bigger scale with business loans too. But it wasn’t always like this, said Greg.

Up until 1914 gold was money. Money was not debt, it was not credit, it was simply gold. The classical gold standard ensured only the credible borrower got credit, and most of the credit extended was business credit.

It was a stable system, but when the First World War came along the system couldn’t cope. There was a run on banks, which led to shrinking credit and shrinking money supply. Gold’s virtue is that it acts as a natural break on the economy when things start to heat up, but as the First World War ramped up this virtue became a failing.

And so in 1922 the system was slowly unravelled with the introduction of the Gold Exchange Standard, which allowed British pounds and US dollars to be exchanged for gold. It ‘…enabled countries to pay for goods and services with debt. Money stopped being gold and became debt,’ said Greg. ‘The world went on a massive credit expansion, leading to the roaring twenties, technological advancement and a global stock market boom.’

Booming debt, technological advancement…does it sound familiar? Greg went on: ‘Credit was created to the point where anyone with a shred of credibility could borrow.’ The system was unsustainable, and the Great Depression struck in 1929, ending the world’s addiction to debt.

‘It took many, many years for the world to accept debt again,’ said Greg. After the depression, the credible person saw debt as something to be avoided, and it had major implications for the financial system.

So another system was introduced in 1944. Known as the Breton Woods System, it pegged gold at the rigid price of $35 per ounce. And for a while the system worked and the global economy chugged along nicely.

But by 1960 the first strains hit. The gold price spiked to $40 an ounce in London, which was a ‘major warning sign something wasn’t right in the system,’ according Greg. It doesn’t sound like much of a price shock, but prior to this the gold price moved in the range of 5–10 cents. So in the early 1960s the US, the Bank of England and European banks got together to control the price of gold by secretly trading with each other — this was known as the London Pool System. That also worked — but only for a while.

Again, war brought shock to the system. Following its decision to invade Vietnam the US printed a lot of money. That money flowed through the global system, and people who ended up with US dollars in their hand decided to swap their dollars for gold. By 1968 volumes in the London gold market spiked massively, forcing the US to fly plane loads of gold to the UK every week.

When the gold market eventually closed for two weeks to cope with the shock, the unofficial price of gold was $44 per ounce. It took another three years for the US to move on from the gold standard entirely.

So what does that tell us about today? ‘If you take a step back and realise the flow of money is slow to manifest in larger changes, it makes you realise these things take time to evolve,’ said Greg. ‘We know the current system [of huge debts] is absurd but could quite possibly go on for 5–10 years. When you think something is unsustainable, it is.’

Today’s unsustainable global finance system took off in the 1980s as debt to GDP exploded, led by what Greg termed ‘iceberg finance’.

The tip of this iceberg, the small visible part, is securitisation. That’s where banks package up the debts on their balance sheets and sell them as securities.

The mostly invisible mass of the submerged iceberg is the shadow banking system where hedge firms, investment banking and insurance companies exist, lending large sums to borrowers.

But to facilitate this lending, securities are swapped between borrowers and lenders as a form of collateral. The same securities are passed on and on to the point where one Treasury note supports a whole bunch of credit.

It’s as dodgy as it sounds, and prone to collapse, according to Greg. ‘It’s not going to take much of a chink in the chain to bring that system down,’ he said.

We saw the disastrous effects of shadow banking when Lehman Brothers went under. It was using securitised mortgage debt as collateral to borrow money and speculate. As a housing collapse swept through everyone realised that this collateral had no value. This caused a run on the banks that nearly brought the whole financial system down with it.

This is how the world got lumped with QE. Greg said that after the financial crisis, government debt was the only form of collateral left in 2008. But Governments can’t just go to the bank to get a loan when they want debt. The government requires the market to buy its debt, but without liquidity in the market, that’s impossible. QE provided this liquidity, so government borrowing could continue.

Global debt is now US$100 trillion and perceived credibility — the belief that this debt will be paid back — is all that’s keeping it together. With QE set to ease in the future, what will happen? ‘I’m not sure how the world is going to cope,’ said Greg.

Greg recommended a prudent approach to navigating this risk. ‘Gold is a great wealth preserver over the long time.’

Holding on to a decent amount of cash is very important too — since no one knows when the proverbial will hit the fan. So too are good value, quality stocks — though Greg believes there aren’t any around at the moment. The search for yield and dividends mean most of the quality stocks in the market are overpriced and share markets look set to deliver very low long term returns at these prices, according to Greg.

If the history of money is anything to go by, then you can bet on a bumpy ride ahead.

Callum Denness
For Money Morning

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Low since previous high: $22.88 (2 April, 2014)

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