What's Really Bothering the Global Financial Markets?

Anatomy of a Dysfunctional Paper-Based Monetary System

September 10, 2001

Part 1


The Root of the Problem: A Banking System That Requires The Issuance of Debt In Order To Function

When Federal Reserve Chairman Alan Greenspan last testified on monetary policy before the U.S. Senate Tuesday in July, he acknowledged a very important situation: There's deflation in Japan, he said, and there’s a problem with the Japanese banking system because they are unable to operate normally.  

Seems they are in such bad shape they couldn't issue any more debt.  This limitation seriously freezes up their ability to do business as banks these days must do business.  As a result, the Japanese government cannot stimulate its economy as many have been urging as the solution to their deflationary spiral, mostly because the banking system is freezing up as a result of very low asset values and balooning problem loans.  With the Nikkei Average so low and Japan's interlocking securities system dragging it down even more, bank asset values have plunged so low Japanese banks reportedly cannot meet international reserve requirements.  More on this on page 2, which takes a look at our the mechanism behind our banking system.

Caught frozen in our own world banking system?  You'd better believe it, and Japan isn't the only country having problems.  Why is this so relevant to U.S. investors?  Not only is it relevant because Japan isn’t the only country with these problems, but because the world's second-largest economy serves as a looking-glass right through those layers of the global economy we talk about and to the roots of the problem.  Japan, then, can be used as a leading indicator of what lies ahead for most or all of the rest of the globe in handling the modern-day version of the deflationary debt spiral.

In fact, there are so many potential global hot spots it makes one hang on the edge of his or her chair every morning, hoping that the news hitting the financial markets is one of meaningful structural solution instead of a 1997-style dominoes collapse.  We hope that the news we hear in the coming weeks involves action resulting from the recognition of the true problems with our system by the leaders charged with managing that system, rather than more of the same: IMF bail-out loans, economic plunge, debt defaults, and reeling financial markets.

Yet, the problem is so severe Japan cannot live with it any more—literally. It is not just a routine item on the evening news in America, as many have hoped the news coming out of the Pacific Rim would be since 1997. instead, it is a painful way of life for the Japanese, who are presently providing the rest of the world with that looking glass view of what lies ahead for much of the world.  Worse yet, Japan is no emerging economy, but the second-largest. Smaller economies like Argentina and Turkey, and many others, are having great difficulty recovering from their problems due to being "frozen in our own system," two, but an economic implosion coming from Japan would truly throw the largest economic tidal wave across the globe since the Great Depression of the 1930s.

Why does the problem appear so dire unless sweeping change to our  monetary system is made virtually immediately?  Let’s take a look inside our current monetary system thirty years after the gold exchange standard was abandoned in 1971, for that is perhaps where both the problem and the solution lie.

Part 2


Abandoning The Gold Exchange Standard: 30 Years Later

After the U.S. replicated its monetary system across the Western world during World War II reconstruction and the subsequent decades following that, the world ended up with a system that requires countries to issue debt instruments in order to monetize their economies.  It also required that most of the debt issued be funded with currency that, since 1971, is backed by literally nothing. Nothing but government fiat and laws that require the use of this paper currency as payment for goods and services. The United States dollar, for example, contains only two key statements: "This note is legal tender for all debts, public and private," and, "In God we trust."  The latter statement, of course, is more meaningful. 

Understanding this mechanism is important.  Below is a synopsis, albeit oversimplified, of how our present global monetary system (Western) works:

  • A central bank (of any particular country utilizing this system) creates debt in the form of a government agency bond or note, typically a Treasury Bill.
  • The central bank creates money by writing a check from "reserves" (actually the power to print money, but no "reserves" actually exist) to pay for the Treasury instrument in the open market.
  • The "check" issued by the Federal Reserve, as the central bank is called in the United States, enters the banking system through open market operations in order to increase the money stock in circulation.  
  • The Treasury debt instrument just issued becomes an "asset" of the government.  However, that "asset" is actually a debt instrument paid for with no existing assets. Instead, paper money is printed to "pay for" the open market transaction.  
  • The newly created money enters the fractional reserve banking system, in which only a fraction of the amount a bank carries on deposit is required to be kept in reserve by the bank. The balance—to the tune of 85% to 88%, depending on current reserve requirements dictated by, of course, the Federal Reserve— is lent out again, this time to consumers who are under legal mandate by the law of the land to use that country's currency as payment for goods and services.  The original injection of money by the central bank's debt instrument, then, has been lent out again, creating more debt—and further expanding money in circulation. Money has been created literally from nothing.
  • Banks then charge consumers interest on this new money created from nothing. More debt upon more debt is created, feeding the banking system with profits which, of course, are shared by investors buying stock in the banks and the corporations using the money injected into the economy.
  • Ultimately, the debt pyramid created from, and backed by, nothing, becomes too difficult to service after years of credit creation. Economies and currencies collapse from the burden, inducing a capital flight episode as private money seeks to avoid risk by rapidly pulling out of problem economies. The pyramid typically begins to collapse when the stock market collapses, kicking off the asset deflation that undermines the pryamid.
  • The capital flight episodes further vacate the troubled economies of necessary capital, contributing still further the destruction of money that is monetary deflation. 
  • Typically the central bank managing the troubled economy jacks up interest rates to extremely high levels in an effort to induce investors to leave their capital where it is.  The skyrocketing interest rates further collapse the economy, providing additional incentive for private capital to continue to flee troubled economies.
  • The entire system collapses, further plunging asset prices and creating a situation in which the banking system cannot function because it can no longer issue more debt and cannot deal with the problem loans nearing default.
  • The inability to issue more debt prevents the creation of money by the central bank that allows the troubled economy's government to stimulate the economy through the monetization of debt.  
  • Since credit is being destroyed, as is debt when it is defaulted upon or forgiven, money in circulation is contracting at a rate that prevents the economy from operating.
  • A liquidity crisis develops from the vacuum created by the disappearing money in circulation, a problem compounded by the slowing velocity of money due to the crisis.
  • The government of the troubled economy then sends out an S.O.S. since it is now in a fatal downward spiral that will lead to total bankruptcy unless the collapse is stopped.
  • The Powers that Be of the global economy, reluctant to give up their political agendas by making the required structural changes to the monetary system, then utilize an existing pool of paper money presently managed by the International Monetary Fund and funded by the printing presses of those Powers that Be, to send money to the collapsing country in an attempt to fill the vacuum caused by the downward spiral.
  • Since the typical solution employed is to utilize more paper and more debt to patch up a collapsing system overloaded with paper and debt, the spiral cannot be stopped until structural changes are employed.
  • This same set of events tends to repeat itself with increasing frequency after a few decades of economic expansion, and the downward deflationary collapse tends to occur 55-60 years or so.
  • The fiat currency system allows governments to advance any agenda since they have infinite funding for any agenda they wish, including war, until the entire system collapses.  When the entire system collapses, citizens of many countries of the world are thrown into substandard living conditions, poverty, and starvation.  Riots and war evolve until the changes necessary to stop the deterioration change.

This is neither a drama nor a science fiction story. It is not a pessimistic viewpoint, for as part of our daily lives it cannot be reduced to a mere viewpoint at all.  Instead, it is a harsh reality, for we can easily see that our present monetary system is based on "assets" empowered by government fiat and by fractional reserve banking reliant on the issuance of debt upon more debt in order to function.   When an economy can no longer issue debt, it's system freezes up, contributing to a slowdown in global economic activity.

Unfortunately, we are on the verge of repeating the same set of events events that occurred during the fiat/deflation/debt spirals of the past, just as we just again created the same type of stock and debt market bubbles in the 1990s that were again followed by the collapse, economic contraction, deflation, and depression already getting underway in the post-1990s environment.

Investors are now quickly learning that the course of economic and financial market events cycles between that which is too easily categorized as optimistic and pessimistic viewpoints. Those who spoke of the risks associated with the chasing the stock market bubble of the late 1990s did not have the luxury of being pessimistic, nor do investors have this luxury now now. What is occurring in the economy now is that harsh reality that is well beyond the common categories that are used to typify emotional sentiment—to rationalize an undesirable outcome into a frivolously pessimistic viewpoint. Will investors or the Powers that Be charged with managing this mess in the global economy make the same mistakes yet again?  Or will they make the required structural changes so that, then, we may be characterized as optimistic.

Unfortunately, political resistance against tossing out a paper currency system that allows any participating government to fund any agenda merely by cranking up the printing presses is enormous—enough to cause a massive increase in the pain and suffering of the average citizen of the world rather than make the necessary changes.  Structural change in order to bring in the new, modified monetary system is necessary to avoid still more pain and suffering.

Although it operates under a slightly different system of interlocking securities(corporations and banks in Japan share in each other's equity, tying each other to the fate of the entire economy), Japan is a classic illustration of a debt spiral in progress, and it is a time bomb that is ticking day by day until the Powers that Be (soon to become the "Powers that Were") get together and unify in a solution that benefits all as much as possible.  It is a time bomb not only because Japan is caught in one of the worst debt spirals of modern times, but because it simply cannot operate because it cannot issue more debt.  A banking system that cannot issue debt is one that cannot function in our present monetary system. 

The present problem in the global economy has no long-term fiat solution.  Each time the IMF lends more paper to prop up a collapsing paper economy, the weight of the debt pyramid becomes even more unbearable.

This, unfortunately, is what is really bothering the global equity markets, and the decline in corporate earnings and capitalization is just one symptom of a greater problem.

Part 3


Solution: Structural Change Is The Only Choice

Solution: There is no choice but to return to a monetary system that is not backed bynothing at all, to use a double-negative to emphasize the root of the problem plaguing our present paper-based, fractional reserve monetary system.  A monetary system that is backed by commodities such as gold and/or silver provides the tangible foundation for an alternate, paper-based system collapsed by the poor discretion of generations pyramiding debt and paper to back more paper.  

Even now, gold retains its value and preserves operational wealth even in a paper-based system. An ounce of gold still buys one fine suit as it did centuries ago, and it buys many other goods and services at the same price as it did repeatedly throughout the centuries as detailed in our 1998 Special Report, Gold In A Deflationary Economy. Fiat currencies of the past several centuries, however, couldn't buy the needle to tailor the suit.Fiat currencies of today repeat results of the same pattern.  In the least, those managing to buy the needle in countries not yet collapsed are now paying many times its former cost.

Without real structural solutions, the problems that began to accelerate in the 1990s will only become worse, until Japan and other regions literally implode in a collapsing debt spiral and the Powers that Be are forced to make the changes that should have been made before, and that should be made now.  Solutions must be implemented now, or Japan will only be the tip of the iceberg, and Dow 10,000 will be a thing of the past very quickly.

Is it any wonder, then, why gold is rallying during a time when deflation, debt problems, and a plunging global economy regularly hit the news?  Gold did not break its 1998/1999 bear market lows against the U.S. dollar even in the face of the worst global collapse in decades with the 1997/1998 Pacific Rim crises, Brazil, Turkey, Russia, Argentina, and now, Japan.  Against many foreign currencies, gold launched an all-out bull market.  Gold is fulfilling our precise forecasts for the present environment detailed in Gold In A Deflationary Economy.  We refer readers to that timeless report featuring studies based on 4½ centuries of data during past inflation/deflation cycles such that the reader may learn of the "rest of" the forecasts contained in that report before they come true, for we are well down the path that leads to the next step for the investment markets, and investor portfolios will be affected greatly.  

Below Japan has entered the free-fall portion of the Kondratieff Long Wave of debt repudiation.  It's accelerating rate of deflation and spiraling debt burden are classic Kondratieff symptoms.

24 karat gold is pure elemental gold.

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